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justaguide eNotes educator| Certified Educator

When companies compete against each other to gain higher profits, there are many strategies that all of them can adopt and each or them knows that their competitors are capable of doing the same too. But none of the companies is aware of whether the strategy is being adopted by their competitor or not. Also, what one company does can affect all the others. The study of the strategies that any company is likely to adopt under these circumstances is a very interesting one in economics.

The Prisoner's Dilemma is a classic case that illustrates what happens in the circumstances mentioned earlier. The case under consideration involves two people A and B who have been arrested for committing a crime but there is not enough evidence to prosecute either of them. What the police do instead is separate A and B and give each of them an opportunity to testify against the other. If neither of them testifies, both go free. But if A or B testifies and the other doesn't, A or B can go free with the other getting a 10 year sentence; if both testify, each gets a 5 year term. In hundreds of studies conducted with human volunteers it is always found that both of them testify against the other. This happens in spite of the fact that the best deal for both of them is to not testify because neither of them is aware of what the other is going to do.

Many similar situations arise between competing companies. For example, if neither of two companies offers a Christmas discount both stand to earn higher revenues; instead what we usually see happening is that a discount is offered by both the companies because each of them is aware that if one of them drops its prices and the other doesn't, the customers of the second would shift to the first with dropped prices.

pohnpei397 eNotes educator| Certified Educator

Since you have placed this in the business section, I will discuss this game in connection with business.  

In this game, two players must decide whether to compete against one another or to cooperate.  They do this without talking to the other or knowing what the other will do.  It is based on the idea of two prisoners being interrogated separately for a crime.  If they both confess and try to implicate the other (if they compete) they both get medium sentences.  If one confesses and the other does not, the one who confesses gets off scot free while the other gets a long term.  If they both refuse to confess, they get short sentences.  In this way, they have to decide what is best for them and they have to predict what their rival will do.

This has an application to business.  If you have a close competitor, the two of you must play a prisoner's dilemma game of sorts.  You must both decide how to price your product.  If, for example, you lower your price, it is the equivalent of confessing in the prisoners' dilemma.  If your competitor also lowers prices, you both lose.  If your competitor keeps his prices high, you win and he loses because you get more market share.  In this way, the prisoner's dilemma can help you think about how businesses work when competing.