Prisoner’s Dilemma and presidential campaigns

I introduced my microeconomics class today to game theory. Doing so gave me an opportunity to explain why US presidential campaigns are filled with so much hateful and ugly rhetoric. Why can’t politicians be nicer, speak to the issues, and avoid the hurling of mud at their political opponents? Why do we see so many negative campaign adds? Game theory, particularly the Prisoner’s Dilemma, provides insight here. In a previous post I described briefly what the Prisoner’s Dilemma is.


Consider this figure, which depicts the campaign strategies of Donald Trump (“Trump”) and Hillary Clinton (“Hillary”). Trump and Hillary can be nice or mean. If both are nice and avoid negative campaigning, they each split the Electoral College (EC) votes, with one getting a few more than the other for a win. The same outcome occurs if both play mean and nasty and spew hateful rhetoric at the other, but now the tone of the campaign is harsh and leaves a bitter taste in everyone’s mouth. With 270 EC votes needed to win, as of this writing Trump was declared the winner with 279 EC votes. Thus they split the EC with Trump getting a few more but doing so with a very negative campaign–an inferior outcome for everyone.

If Trump is nice and takes the high road but Hillary is mean, she will get most of the EC votes. Similarly, if Hillary takes the high road while Trump is mean, he will win most of the EC. In other words, negative campaigning works, which is why both have an incentive to campaign negatively. That is, both Trump and Hillary have a dominant strategy to sling mud. Regardless of whether Hillary is nice or mean, Trump is better off being mean and campaigning negatively–when Hillary is nice, for Trump getting most of the EC by being mean is better than getting about half by being nice, and when Hillary is mean, getting about half of the EC by being mean is better than getting only a few EC votes by being nice. Similarly, regardless of whether Trump is nice or mean, Hillary is better off being mean and campaigning negatively. This produces a classic Prisoner’s Dilemma outcome.

Most people will prefer that the candidates remain nice and civil during the campaign. For example, the Pew Research Center said this (here) about this year’s presidential campaign: “The presidential campaign is widely viewed as excessively negative and not focused on important issues. Just 27% of Americans say the campaign is “focused on important policy debates,” which is seven points lower than in December, before the primaries began.” Interestingly, a 2000 Gallup survey found that “negative campaigning [is] disliked by most Americans” and that most people felt that the presidential contest between Al Gore and George W. Bush “may be one of the most negative presidential elections in recent history.” Maybe every presidential contest is the worst one in history.

But since the game candidates play is a Prisoner’s Dilemma, the expected and actual outcome is one in which both are mean and nasty.

How do we resolve the Prisoner’s Dilemma in this case? Standard solutions that scholars have examined, such as repetition and institutional rules promoting cooperation and punishing defection, can’t apply or won’t work in political campaigns. The only seemingly viable option is for players of the Prisoner’s Dilemma to have high moral values so that they avoid the incentives to be mean to each other. If both players of this game are virtuous and possess high integrity, and each knows the other player is that way, then maybe we can see political campaigns and elections that are civil and informative.

Prisoner’s Dilemma in the classroom

The Prisoner’s Dilemma is a model that illustrates a conflict between the interests of individuals and the interests of those individuals as members of a collective or group. In most versions of the game, two or more persons can cooperate and receive a collective reward that is greater than the sum of individual rewards they could earn if they choose not to cooperate. The incentives of the game are such that the persons have an individual incentive not to cooperate, thus making them collectively worse off had they chosen to overlook their individual interests and instead think as a group. The game is famous in economics and other social sciences. Wikipedia has a lengthy discussion of the game, its refinements and implications here.

Even though the Prisoner’s Dilemma has been around for decades it is still a fun game to play with students. In my microeconomics class today I offered the following opportunity for the class to earn extra credit:

“You can earn extra credit by selecting the amount of extra credit points you want. However, if more than 4 of you select option B, then the entire class will receive 0 extra credit points.”

Option A was to earn 1 point extra credit.
Option B was to earn 4 points extra credit.

I use a web-based student response system so that students could register their choice on their cell phones and I would see the results immediately. Not surprisingly, of the 180 in class today, 10 chose option B, leading to no extra credit for the class. When I gave the class a chance to do it over again and even talk to each other, the number who chose option B increased to 17.

The incentives to choose option B are pretty strong here — getting 3 more extra credit points than one could get by cooperating with everyone else in the class and getting just 1 point. Even when I changed the payout structure so that option A gave 3 points and option B 4 points, there were 6 students who still chose option B, thus negating the extra credit opportunity for everyone.

What I find interesting here is not that there were some students who chose option B but that so many in the class chose option A. At least 90 percent of students were willing to forgo their individual interest of choosing option B in order to cooperate for the collective good.

In economics we teach that when people pursue their self-interest things will work out the best for everyone. But sometimes they don’t. Sometimes the pursuit of one’s interests can be damaging to others and the collective whole. Why does self-interest work in some cases but not in others? And when the incentives for collective action are not ideal, what can we do to encourage or promote more cooperative thinking and behavior?

Russell Crowe, in the movie A Beautiful Mind, played the mathematician John Nash who developed this idea. He explains the problem and solution nicely in this clip from the movie.

I asked my class these questions and got a lot of interesting responses. Because the student response system I use saves student responses, I can list some of them here:

“Anonymity is the problem”

“People only act in their self interest and don’t want to work as a whole for the better of everyone”

“so basically we need to be communists in order for this game to work”

“People are greedy”

“people think they deserve it more than others”

“Throw tomatos (sic) at the people who chose B”

“you do what you have to do”

“Take away the second option”

“build a wall make the people who picked B pay for it”

“this game don’t work cause we got more than 4 selfish people in class”

“Not as many laws and restrictions”

“Because people think that everyone else will pick A and that they will end up getting more when in reality they hurt everyone else”

“Need more communication and honesty”

“Sometimes selflessness is the answer”

“If people weren’t greedy then we would at least be able to get one point extra credit”

“All it takes is one bad egg to ruin it for everyone”

“punish those who answered B”

“Communicate with others to achieve extra credit”

“Put people who choose B in jail”

“freshmen think that 1 point if extra credit is actually going to influence their grade”

“do your work maybe you wouldn’t need to pick B”

Resolving the Prisoner’s Dilemma requires careful structuring of the way people interact and enforcement of the formal rules and informal norms we develop to promote cooperation. It also requires that people exercise self-restraint in the pursuit of their self-interest, since no rules or monitoring mechanisms are perfect. We wouldn’t (or shouldn’t) want to live in a society where such rules are perfectly enforceable. How to do this so as to protrct one’s freedom to choose makes for a fun discussion in class.

In the end I gave everyone in the class who chose option A in the last round of the game (in which 3 points were possible) the 3 points extra credit. I don’t know if the class learned much, but I hope they left feeling better about their teacher.



When is an increase in price fair?

In my previous post I wrote about the fairness of drug companies that dramatically increase the price of their products. I suggested, and public reaction confirmed, that these price increases are considered unfair.

When is a price increase fair? When is it unfair?

The economic principle of profit maximization tells us that firms ought to increase prices when there is an increase in demand or a decrease in supply, regardless of whether the change is short-term or permanent. So if a hurricane is closing in on the East coast of the U.S., then suppliers of lumber, bottled water, gasoline and other supplies that people will need should and will increase the prices of these things … a lot. But is that fair?

Daniel Kahneman, Jack L. Knetsch and Richard Thaler published a paper on this topic 30 years ago in the American Economic Review. They argued that people’s perceptions of fairness will (or ought to) constrain impulses to take advantage of short-run increases in demand or other reasons to increase prices, under certain conditions.

Their discussion entails two elements. One has to do with reference points and the other has to do with reasons for gaining at the expense of others.

First, a reference point is the basis upon which people create expectations about the fairness of a transaction or a change in prices. If transactions or price changes are consistent with the reference point, then people will judge the transactions or price changes as fair. In other words, reference transactions and reference profits are considered fair. If there is a deviation from the reference point, then assessments of fairness will be made based on whether good reasons exist for the deviations.

The authors define the reference points as follows:

Market prices, posted prices, and the history of previous transactions between a firm and a transactor can serve as reference transactions. When there is a history of similar transaction between firm and transactor, the most recent price, wage, or rent will be adopted for reference unless the terms of the previous transaction were explicitly temporary. For new transactions, prevailing competitive prices or wages provide the natural reference.

For example, if a gas station has been selling gas for $1.99 a gallon for several weeks, then the reference price is $1.99 a gallon, and people will expect that to be the price the next time they get gas. If the price of gasoline increases, say to $2.09 a gallon, then people will likely consider the price increase unfair unless they understand there to be a good reason for the change. Good reasons have reference points, too. For example, raising prices at the expected rate of inflation is not considered unfair, since inflation-based price increases can be a reference point. We have historical experience with that, so there is no basis for claiming unfairness. The same about price changes in gasoline. If the reference point for price changes is 5 cents a gallon, then people won’t be bothered by finding the price of gasoline is higher by 5 cents the next time they buy gas. But if prices increase by more than 5 cents, then they might believe or expect something unfair is happening at their expense.

Understanding reference points for transactions, pricing and profits can help us understand why unfairness might be claimed when businesses increase prices. For example, if employees had previous experiences of getting pay increases when competitors raised their employees’ wages, then a reference point is created for employees. But if the employer has not historically increased wages when their competitors have, then the reference point for the employer will differ from that of the employees, resulting in disagreements about fairness.

Second, an important principle of fairness is that one should not gain by imposing a cost or harm on others.

Raising the price of lumber, bottled water, gasoline and other supplies that people will need when a hurricane is imminent can be considered imposing a harm on others to acquire a short-term gain. It doesn’t matter that economics dictates that price increases are needed to resolve shortages that will arise when there is a sudden increase in demand. There is usually no viable reference point for such behavior.

Raising prices because a business experiences an increase in costs is different. Such behavior is not considered as imposing a harm on others merely to benefit at their expense. Businesses are not gaining substantially, if at all, when they increase prices to cover their rising costs.

The implication is that people are willing to accept as fair an increase in price to cover rising costs. They also consider it fair for businesses to maintain prices when costs decline. But people consider raising prices when demand increases or without explanation or justification to be unfair.

Most people have no reference point for drug prices rising 5000 percent or even 500 percent. Such behavior is very unfair.

Because they can, but should they?

Mylan is the company that produces the EpiPen, a device that injects a measured dose of epinephrine when someone has a severe allergic reaction. Mylan didn’t invent the drug or device. The company acquired it in 2007 from Merck, which bought the rights for the drug years earlier from another company. By some estimates, Mylan’s EpiPen controls roughly 90 percent of the market for epinephrine injection devices. When Mylan purchased the rights to the EpiPen in 2007, the drug cost about $100 for a two-pen set. It currently retails for more than $600.

Mylan isn’t the only company to buy a drug and then dramatically increase its price. Earlier this year, the Wall Street Journal (as well as other news outlets) reported on pharmaceutical companies that buy rival’s drugs and then jack up the prices. A noteworthy example is Martin Shkreli, a hedge fund manager and CEO of Turing Pharmaceuticals, who bought the drug Daraprim and raised its price from about $13 a dose to $750. The drug is used to treat a variety of infections and other diseases. Turing bought the rights to the drug from a company, which bought the rights to the drug from another company, which bought the rights to the drug from another company, …

Why did Mylan increase the price of the EpiPen? Why did Turing increase the price of the drug Daraprin? Because they can. The companies control exclusive rights to the drug and the demand for the drugs are highly inelastic. First, by having exclusive rights over the drugs and with little if any competition, they possess monopoly power. This means they can act as price makers rather than price takers. Second, as I explained to my microeconomics students today, demand for the drugs is inelastic because there are few substitutes to them and they are necessary. This means that consumers will not (or cannot) be very responsive to large changes in prices. If you are subject to severe allergic reactions, you probably will not forgo the drug if its price increases. You will grumble and complain but buy it anyway. Thus, the combination of monopoly power and inelastic demand makes raising prices economically rational.

The drug companies and other commentator point to other reasons for high drug prices. Some argue that the patent system and long and costly regulatory approval processes are to blame. While these affect the initial costs for many drugs, they don’t explain why the price rose so quickly years after the drug has been on the market. If Daraprim was profitable at $13.50 a dose, then patenting and regulatory costs won’t explain the 5,000 percent increase in its price after Turing bought it.

According to an article in today’s Wall Street Journal, drugmakers are pointing a finger at middlemen for rising drug prices. Drug company executives say that the system is to blame. Everyone has to take a cut, such as pharmacy-benefits managers. Drug companies say that they have to offer increasingly larger rebates to pharmacy-benefits managers to induce them to accept their drugs as part of their company’s health plans. These benefits managers, in turn, are blaming drug prescription services and health insurers. While there might be some merit here, it’s hard to believe that middlemen and insurance companies are largely responsible for the dramatic increases in drug prices. I can’t imagine that a benefits manager will say “no” to the only drug that is available to treat severe allergic reactions or some infections. Drug companies won’t have to offer large rebate inducements if their drug prices were not already very high.

To be sure, the problem is complicated. Should we force drug companies to price their products “reasonably”? What is a reasonable price for a life-saving drug? Who’s to say that $20 or $30 or even $50 is unreasonable for Daraprim? These companies also employ thousands of workers and their stocks are part of savings, retirement and other investment portfolios for many people. If we mandate lower prices for drugs, then what happens to drug company employees and investors?

If drug companies can raise prices, and justify the price increases on economic grounds, then should they? Economic considerations are important, but they are not the only values that matter. Fairness matters too. Is it fair to ask patients to pay 5000 percent more for a lifesaving drug?

Fairness can be more difficult to justify than economic rationale. But we can simplify things. While there are many bases for arguing “fairness,” all of them are grounded in expectations. When our expectations are met, then we have little grounds for arguing unfairness. However, when expectations are not met, people typically feel justified in claiming unfairness. Consumers with a history and experience in paying $13.50 for a drug to treat infections will continue to expect that prices will be about the same the next time they buy the drug. While most people can expect gradual increases in prices, for instance due to inflation, there is no reasonable argument anyone can make that would convince me that consumers would expect a 5000 percent increase for Daraprim or a 500 percent increase for the EpiPen in a relatively short period of time. If drug companies want to increase prices more than what consumers expect, then the companies need to speak directly to consumers and change their expectations. That is fair. But I expect that will be quite a challenge for drug companies.


Business leadership and the making and punishing of unethical employees

A study published in the current issue of Business Ethics Quarterly links ethical leadership with improved engagement of employees at work, greater employee voice and lower intentions for employees to exit. In other works, when employees perceive or know their leaders to be ethical, they are more likely to feel good about being at work, more willing to communicate their opinions, recommendation, concerns or ideas to their supervisors, and less likely to leave or intend to the leave the business.

In this context, an ethical leader is someone who is a moral person and who models high moral standards at work. The specific indicators of ethical leadership used in the BEQ paper draw from research by scholars at Pennsylvania State University. If valid, the indicators are informative. There are 10 of them. Ethical leaders

  • conduct their personal lives in an ethical manner
  • make fair and balanced decisions
  • can be trusted
  • ask what the right is when making decisions
  • listen to their employees
  • discuss business ethics and values with their employees
  • have the best interest of their employees in mind
  • set an example of behaving ethically at work
  • discipline employees who violate ethical standards
  • define success by the way results are obtained in addition to results.

I would add one more item to the list. When designing and implementing performance measures and incentives, ethical leaders are careful to ensure that they are promoting incentives rather than pressures to perform. The line between incentive and pressure can be thin. Leaders who are not careful may find that their efforts to motivate workers create pressures for them to lie, cheat or steal.

The CEO of Wells Fargo is learning this lesson the hard way. According to the Wall Street Journal’s report of John Stumpf’s testimony during a Senate Banking Committee hearing yesterday (September 21), the Bank is accused “of fostering a culture where low-paid branch employees were pressured to meet impossible sales quotas to keep their jobs, and so signed up customers for products without their knowledge.” Pressure does not create an environment where employees behave ethically. Even well-meaning employees may find the temptation to fudge numbers or behave inappropriately too strong in such an environment. The Bank reported that it fired more than 5,000 employees for wrongdoing.

So, Wells Fargo created unethical employees and then punished them.

Reminds me of the statement by Thomas More in his book, Utopia, made famous by Drew Barrymore’s character Danielle (aka Cinderella) in the movie Ever After. Danielle is arguing with Henry, the Prince of France, for the release of her servant, who is bound with other poor and destitute prisoners for the America’s. Here is the exchange:

Danielle: A servant is not a thief, your Highness, and those who are cannot help themselves.

Henry: Really! Well then by all means, enlighten us.

Danielle (quoting More): If you suffer your people to be ill-educated, and their manners corrupted from infancy, and then punish them for those crimes to which their first education disposed them, what else is to be concluded, sire, but that you first make thieves and then punish them?

Henry: Well, there you have it. Release him.

That’s quite a commentary about one of the nation’s most prominent banks.

Potash peril

Potash refers to a variety of compounds that contain potassium. Plants require potassium (chemical label is K) for their development, along with Nitrogen (N) and Phosphorus (P). These three chemicals are the key ingredients of fertilizers and are thus widely used in plant agriculture.

The largest potash producer in the world in terms of production capacity and market value is Potash Corporation of Canada. It has a market value of roughly $14 billion and controls 15 percent of global production and 19 percent of production capacity, according to the company’s website. There are larger companies in minerals and mining (e.g., the UK’s Rio Tinto Group), but none dominates potash production like Potash Corp.

The Wall Street Journal reports today that Potash Corp is merging with Agrium, also a Canadian fertilizer company, the combination of which will be a company with $21 billion in annual revenue and controlling 23 percent of global potash production capacity but 60 percent of capacity in North America. The two companies justify the merger as we might expect–stabilizing prices, lowering production costs, accessing other markets, etc.

Now, if US farmers want to buy fertilizer, they will likely have to get if from the combined company. Farmers are concerned, as they should be. According to the WSJ, “The deal likely would sow further unease among North American farmers wary of reduced competition and higher prices as top seed and pesticide developers pursue their own tie-ups. Already grappling with a three-year slide in major crop prices, some farmers are concerned that mergers between some of the world’s largest farm-supply companies will consolidate pricing power among fewer players and lead to higher costs at a time when farmers are scrimping to eke out profits.”

Efficiency is good, as are lower costs. But as I noted in a previous post, so is choice. Where do we draw the line when struggling with efficiency versus choice? Will the combined company pass on the cost savings to farmers by lowering prices of fertilizer? I hope so. But then I hope for $100 bills to rain on my home, too.

Consolidation in the agricultural seed and chemical industry

The Wall Street Journal reported that German company Bayer increased its share-price offer for the purchase of Monsanto. If (or when) the merger happens, the combined company will dominate an already-concentrated agricultural seed and chemical industry. I don’t have current figures on global industry concentration ratios, but the main players in agricultural seed and chemicals are Monsanto, Syngenta, DuPont, Dow Chemical, BASF and Bayer. According to the WSJ article, Monsanto previously tried taking over Syngenta but failed, DuPont and Dow Chemical are merging, and China’s National Chemical is buying out Syngenta. Monsanto is also seeking an alliance with BASF.

These companies are already tightly aligned. For example, all participate in cross-licensing agreements with each other in a host of technology sharing arrangements, most notably in genetically-engineered seed traits. Phil Howard, a sociologist at Michigan State University, graphically documented these relationships in 2013 (see his cross-licensing agreements and seed industry structure graphics). The Farm Journal provides a similar report (here), with graphics for the top five seed companies in each year from 2010 to 2014.

Many economists support mergers like these in the name of increased efficiency. Often there are economies of scale associated with the development and distribution of technologies, such as genetically modified crops and agricultural chemicals, which can lower costs for firms and, in theory, for buyers of the companies’ products. This is a good thing. But when choice is reduced in the name of efficiency, I wonder whether it is always worth it. Having options is powerful. Limiting choices has the potential to create dependencies and redistribute power. Are farmers’ and consumers’ interests really served by having fewer companies serve them? Some may say that choices and options will not be affected, since the products offered by the companies would still be available. But when they are offered by one firm rather than many, is that really the same?

Efficiency is good, but so is choice. Can we seek a balance of efficiency and choice?