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Prisoner’s Dilemma and Self-enforcing Contracts

“Two men suspected of a crime are arrested. Though there is no evidence to convict them on a principal charge, there is enough to convict them on a lesser charge. Each prisoner is put in solitary confinement and presented with the same bargain: If the first one will testify that the second one committed the crime, while the second prisoner remains silent, then the betrayer will be released and the betrayed will serve ten years in prison. If both remain silent, they will serve 6 months in prison on the lesser charge. If both testify, they will serve five years in prison. Each of them must make a decision independently, not knowing whether the other kept his silence. What should they do?”1

This is a standard problem known in game theory as the “prisoner’s dilemma”. It shows a situation in which the best strategy is to betray the other person regardless of this person’s actions. Consider the options: If the second prisoner remains silent, the betrayer will go free. If the second prisoner betrays, the first one can reduce his sentence by five years. But this shows that in certain conditions two rational individuals acting according to their selfish interest will achieve worse results than if they were to cooperate. The result of mutual betrayal, which is the most rational action here, is five years in prison for both suspects. Had they remained silent, both would serve only half a year.

In everyday life we conduct many transactions where it is potentially more profitable to cheat the other party than to remain honest, just as in the case of the prisoner’s dilemma.2 For example, probably each of us at least once was poorly served in a restaurant, and were left feeling cheated. The restaurant could have boasted on the Internet that it uses only the freshest of ingredients, while serving a piece of frozen food reheated in a microwave. But how many people actually go to court seeking redress in such cases? Hardly anyone. If no one sues the crooked restaurants, then what stops them from cheating all of their clients? After all, would such businesses not increase their profits, had they systematically gave smaller portions than described in the menu, used cheaper ingredients of inferior quality, had their bills constantly “mistaken” in their favor and so on? Why is it that the overwhelming majority of restaurants make sure that customers are well served and satisfied? And, vice versa, why is it that most customers do not leave without paying, even when no one is looking? Why do stores do not constantly try to cheat us?3

This is because reality does not resemble a one-time prisoner’s dilemma; it is closer, instead, to an iterated prisoner’s dilemma – a game repeated many times. In each round, players have the opportunity to punish the other party for cheating in the last round. In the iterated prisoner’s dilemma, if the total number of rounds is unknown to the players, the “always betray” strategy ceases to be best. Instead, the best approach is the strategy known as “tit for tat”: start from cooperation, then do what the other party did in the previous round. Such a strategy can lead to lasting mutual cooperation and, as the economist Peter Leeson suggests, essentially people follow this strategy in the market.4 Moreover, as economist Gordon Tullock points out, most transactions in the real world are not conducted between prisoners. Everyone is free to choose a person to buy from or refuse to sell to, and mutual communication is allowed. A choice of a partner is neither imposed nor prohibited.5 Thus, in the real world, in contrast with the classic framework of prisoner’s dilemma, the rational strategy is to cooperate.

How can a client that feels cheated respond? First of all, he can communicate this feeling to the manager, giving the manager a chance to make amends. If this does not help, the client can avoid this restaurant in the future. After that, he can warn his friends that they should avoid the place, and can even discourage more potential clients by writing a very unfavorable opinion on the internet. A dishonest establishment loses more than a possibly regular client; by losing its reputation, it discourages other potential clients. The gains from sustained honest cooperation are higher than the fleeting “profit” from fraud. Even though the restaurant owner knows that the client probably will not turn to authorities to seek redress, the owner is more likely to abide by his contract, because the gains from future cooperation far outweigh the gains from cheating. This is due to what is called the self-enforcing contracts. In a few words’ it means that no third-party contract enforcer (e.g. police or courts) is needed to enforce contracts, because we are able to “punish” a dishonest party on our own. What is more, this is probably the most common and effective form of contract enforcement mechanism used in our daily life. Even if both parties know that the client will never come back to the restaurant, the owner will still treat the client honestly, as he would a continuous visitor, because otherwise the customer might inform other potential clients of his dissatisfaction.6

Certain conditions must be met if the contracts are to be self-enforced in an effective manner.

The first condition is that interactions between the parties must be repeatable. Otherwise it must be possible to spread the word about a cheater to a significant fraction of other potential parties. The internet makes it easier. You can use the internet to inform other people quickly and almost without cost. There are, however, some situations in which these conditions are not met. For instance, you can go on a trip to a country crowded by tourists, and you do not know the native tongue. A seller knows that you are a tourist, and that your opinion will be received only by a relatively small group of your friends or fellow countrymen. He can ignore them, as they live far and are only a small fraction of his potential clients anyway. In such case it is more likely that you will be cheated.7 In his article on self-enforcing contracts Stanisław Wójtowicz, PhD, writes:

“You have certainly heard a tip about eating abroad: ‘Choose places where locals eat. Avoid places for tourists.’ This advice is valuable not because locals know their food better than tourists, but because unlike restaurants for tourists, the restaurants they themselves eat in are subject to the self-enforcement mechanism described here. The value for money ratio will be many times higher in a small pizzeria that is frequented by a local community and lies off the beaten track, than in a restaurant in St. Mark’s Square in Venice.”8

The second condition is low time preference of the parties to the exchange. If the seller has to pay protection money to the mafia tomorrow, then the quick-money scheme at the cost of losing some customers will be more valuable to him than the long-term profits of cooperation.9 Such situations, however, are rare.

The third condition is a small ratio of gains from cheating to the funds invested in the business. If someone, for instance, runs a small business in which he invested little and gets minimal profits, and has a chance to cheat the client for a very large sum of money, then the economic incentive to do so is strong. This is implied by definition, as the parties must value the gains from long-term cooperation more than the gains from a one-time fraud. Of course, it does not mean that whenever there is an economic incentive to cheat, someone necessarily will be cheated. Fortunately, human beings care about lot of things besides money. Many people do not cheat because of their morality, even though there are incentives to do so and they do not fear punishment. In such situations, though, the parties do not need to rely on the mechanism of self-enforcing contracts hereby described.

It is worth noting that self-enforcing contracts work not only in small transactions, but also in entire industries that involve large sums of money, as the diamond industry or cattle industry. For those of you eager to learn more we have prepared a few links under the article on our website.

For the website:
Lisa Bernstein, Opting out of the Legal System: Extralegal Contractual Relations in the Diamond Industry

Robert C. Ellickson, Order without Law: How Neighbors Settle Disputes

Bruce L. Benson, The Enterprise of Law: Justice Without the State

Stanisław Wójtowicz, Samowymuszające się kontrakty (Self-Enforcing Contracts)

2  G. Tullock (1985) “Adam Smith and the Prisoners’ Dilemma”, The Quarterly Journal of Economics, 100 (Suppl.), p. 1073

3  Based on P.T. Leeson, Contracts without Government

4  Ibid, p. 9.

5  G. Tullock (1999) “Non-prisoner’s dilemma”, Journal of Economic Behavior & Organization, vol. 39, issue 4, p. 455.

8  S. Wójtowicz, Samowymuszające się kontrakty (Self-Enforcing Contracts)