Explain how the prisoners' dilemma can be used to examine pricing strategies in an oligopoly.

 

The prisoner's dilemma refers to a paradoxical situation where two persons/ prisoners are faced with a decision whether to cooperate and work together or act selfishly in their own self interest. If they cooperate, they both gain but if they act selfishly, they both lose.

Step-by-step explanation

Firms in an oligopoly may choose to collude in order to increase levels of profit. The notion that greater levels of profits will be achieved through cooperation encourages firms in an oligopoly to cooperate. However, these arrangements are generally not stable, as some firms that are doing better than the rest may be tempted to defect from this arrangement in order to benefit more. This usually leaves the other firms worse off because the defecting firm would most likely reduce prices in order to increase their share in their market. A pricing strategy that most firms in an oligopoly use is that of price leadership where one company, usually one that has a bigger market share, leads by setting its price and the other firms follow. From this observation, we can see that firms in an oligopoly are interdependent and the actions of one firm affect the other firms, just like in the prisoner's dilemma.