Cambridge International as and a level Economics Ebook

Pricing strategy and the prisoners’ dilemma
Suppose two prisoners A and B are waiting in their 
cells at night. Tomorrow morning they have to give 
their respective pleas of ‘Guilty’ or ‘Not guilty’. Both 
had been arrested for the same crime. Th
e judge and 
jury knew that one of them was guilty but were unsure 
whether both were. If both prisoners were to plead guilty, 
then both would be assumed to be guilty and given a 
four-year sentence. If one were to plead guilty and the 
other not guilty, the one pleading guilty would receive 
a sentence of eight years in prison; the other would be 
assumed not guilty and therefore released. However, if 
both pleaded not guilty, then both would be assumed to 
have committed the crime and would receive six years in 
prison. Th
e dilemma for both is how they should plead, 
guilty or not guilty?’
A pay-off matrix can be drawn up to show these 
options:
B
Confess
Deny
A
Confess 4/4 0/8
Deny 8/0 
6/6
Th
e obvious conclusion is that turning the other prisoner 
in is the best response. By remaining silent, a prisoner 
runs the risk of being hit with a long sentence, eight years, 
while the other prisoner walks away. By speaking up and 
saying the other is guilty, a prisoner hopes that the second 
prisoner remains silent, in which case he goes free. On the 
other hand, if both prisoners speak, they both get some jail 
time; the risk of remaining silent is seen as greater than 
the risk of speaking out.
So what has this to do with Economics and the 
theory of the firm? It can be used to show some of 
the strategies involved when firms are deciding their 
pricing strategies. 
Game theory
suggests that firms 
are unlikely to trust each other, even in a cartel. This 
is especially the case if a decision has been taken to 
increase prices. Not all members can be trusted to keep 
in line. Some, for example, may keep prices the same in 
order to gain market share from their rivals even if this 
is only for a short time. This point will be elaborated 
below when looking in more detail at the behaviour 
of oligopolists.
Game theory: 
where competing firms exhibit 
interdependent behaviour whereby the actions of one will 
impact on all other firms.
KEY TERM