What Is the Prisoner's Dilemma in Economics?

The prisoner's dilemma in economics describes a situation where two firms each make a choice that seems best for them individually, but both end up worse off than if they had cooperated. At A Level, it helps explain why collusion between firms in an oligopoly can be difficult to maintain. Collusion means agreeing to limit competition, for example by keeping prices high.

A simple example

Suppose two firms can keep a high price or secretly undercut it. The figures below are illustrative profits, with Firm A’s profit shown first:

If both firms keep the high price, each earns $8$. But Firm A can earn $12$ by undercutting while Firm B keeps its price high. Even if Firm B undercuts, Firm A earns $4$ by undercutting rather than $2$ by keeping its price high. Firm B faces the same choice. So both undercut and earn $4$ each, although both would have earned $8$ by maintaining the high price.

A pay-off matrix is a table showing the outcome of each combination of choices. Here, undercutting is each firm’s dominant strategy: it gives that firm the higher profit whatever its rival does. The result shows why an agreement that benefits both firms may be unstable when each has an incentive to break it.

This outcome is an equilibrium: once both firms undercut, neither can increase its own profit by changing its choice alone. It does not mean that undercutting is best for the firms as a group. In a real market, the outcome depends on assumptions such as whether firms can observe each other’s prices and whether they expect to compete again.

Exam mistake to avoid: Do not say the firms choose the outcome with the highest combined profit. Explain each firm’s incentive given the other firm’s possible choice.