Game Theory and Business Strategy

Solutions to Self Test

Collusion & Trigger Strategies


Question 1

Two firms are playing an infinitely-repeated prisoner's dilemma pricing game of the following form:
   Firm 2
   low high
Firm 1 low
5 , 5 20 , 0
0 , 20 10 , 10
high

The firms simultaneously set prices at regular intervals. In the equilibrium of this game, each firm selects the low price. While the equilibrium results in profits of $5 for each firm, collusion can potentially result in payoffs of $10. The firms utilize trigger strategies in order to maintain the collusive outcome.

Suppose that both firms adopt the grim trigger strategy. They continue colluding until one of them cheats. Upon one of them defecting, they play the equilibrium strategy for the rest of the game. What has to be true about the interest rate (r) for collusion to be sustainable?

SOLUTION:

If the firms employ a grim trigger strategy, then each firm will collude if the present value of future discounted profits from colluding is greater than the present value of all future profits from cheating once and playing the equilibrium in every future period:
PV(collude)= 10 + 10/(1+r) + 10/(1+r)2 + 10/(1+r)3 + ...
= 10 + 10/r
PV(cheat)= 20 + 5/(1+r) + 5/(1+r)2 + 5/(1+r)3 + ...
= 20 + 5/r
In order for collusion to be sustainable, we must have PV(collude) > PV(cheat):
  • 10 + 10/r > 20 + 5/r
  • 5/r > 10
  • r < 1/2
r < 25%
r > 25%
r < 50%
r > 50%


Question 2

In the game from question 1, suppose that both firms adopt a tit-for-tat strategy. They initially collude. In future periods, a firm colludes if its competitor did in the previous period, and elects the lower price if its competitor cheated in the previous period. What has to be true about the interest rate (r) for collusion to be sustainable?

SOLUTION:

If the firms employ a tit-for-tat strategy, then there are two types of "cheating" we need to consider. The first involves a firm cheating in every period. In order to prefer collusion to cheating in every period, we require r < 1/2. This is equivalent to the solution for question 1. The second type of cheating involves a firm cheating once, then selecting the high price in the second period in order to regain the collusive outcome.
PV(collude)= 10 + 10/(1+r) + 10/(1+r)2 + 10/(1+r)3 + ...
PV(cheat)= 20 + 0/(1+r) + 10/(1+r)2 + 10/(1+r)3 + ...
In order for collusion to be sustainable, we must have PV(collude) > PV(cheat)
  • 10 + 10/(1+r) > 20 + 0/(1+r)
  • 10/(1+r) > 10
  • 1+r < 1
  • r < 0
But r<0 appears nonsensical. Recall that r represents the interest earned on our investment. If r is less than zero, that implies that we expect our money to depreciate quite quickly. Another way of interpreting this is to think that for collusion to be sustainable, we have to value $1 a year from now more than a $1 today.
Why do we get this strange result. In this game, collusion results in $10 every year. On the other hand, I can adopt a strategy in which I cheat today, agree to suffer some losses next year, and then resume colluding. The tradeoff that I face is earning $10 this year and next, or $20 this year and $0 the next. Obviously, the latter is more preferable regardless of the interest rate.
r < 50%
r < 0%
r > 25%
r < 25%