How the Prisoner’s Dilemma shapes policy & markets

The Prisoner’s Dilemma is a foundational concept in game theory that shows how rational choices made for personal gain can lead to worse outcomes for all parties involved.¹ It describes a scenario in which two people are arrested for a crime and interrogated separately. Without knowing what the other will do, each must decide whether to cooperate by staying silent or to betray the other by testifying.

There are three potential outcomes for this scenario:

1. If both cooperate, they each receive a light sentence.
2. If one defects while the other cooperates, the defector goes free while the cooperator receives the harshest penalty.
3. If both defect, they each receive a moderate sentence, worse than if they had both cooperated.²

The dilemma in these scenarios lie in the incentives. Regardless of what the other does, each prisoner has a strong reason to defect. As a result, both often choose to betray, leading to a worse outcome for both.

This scenario demonstrates the tension between individual rationality and collective welfare. The decision to defect is what game theorists call a Nash equilibrium, which is a stable outcome where neither party benefits from changing their choice alone.³ While this makes the outcome stable, it’s not ideal. It does not achieve what economists refer to as Pareto optimal, which is a state where no one is worse off and at least one party is better off. In the Prisoner’s Dilemma, mutual cooperation would have led to a better result for both, but the structure of incentives is what prevents that outcome.⁴

More than just a theoretical puzzle, the Prisoner’s Dilemma reflects the difficulties of aligning interests in economic decision-making. In macroeconomics, it can be used to explain why governments, central banks, and corporations sometimes make decisions that are individually rational but may not align with broader collective outcomes. To better understand its relevance, below are several scenarios where the logic of the Prisoner’s Dilemma plays out in practice:

Policy coordination

Within a macroeconomic setting, different institutions, such as central banks and fiscal authorities, often pursue separate objectives. For example, a central bank may focus on controlling inflation, while fiscal policymakers place greater importance on growth or employment. Even when both aim to support the economy,limited coordination between the two can sometimes lead to outcomes that are less effective or not fully aligned.

Case in point: Hungary (2013-2023)

Between 2013 and 2023, Hungary experienced periods of economic imbalance, which some studies have associated with challenges in policy coordination. During this time, the government increased public spending to stimulate growth, while monetary responses did not always adjust in parallel to address emerging inflationary pressures. This example illustrates how, even when policy actions are well-intentioned, the absence of synchronised timing or shared objectives can lead to less optimal outcomes for the broader economy.⁵

Public goods and shared responsibility

The Prisoner’s Dilemma offers valuable insights into why public goods, such as clean air, infrastructure, or national security, may sometimes be underfunded. These goods provide broad benefits, but individual actors often lack a direct incentive to fully shoulder the cost of providing them. As a result, there may be a tendency to wait for others to act, leading to overall undersinvestment.

This dynamic is particularly relevant in climate policy. Addressing global emissions requires a collective effort, yet individual countries may find it challenging to implement significant changes if they perceive others are already making progress. International agreements, like the Paris Agreement, aim to align incentives and encourage joint action, although the challenges of securing full participation and preventing free-riding remain an ongoing consideration.⁶

Market competition and strategic behavior

In markets dominated by a few large players, companies often face a strategic dilemma. For instance, if all firms hold back from aggressive pricing, they can maintain healthier profit margins. However, each fears that competitors might cut prices to gain market share, so they do the same. The result is a price war that reduces profits across the board.

This reflects the Prisoner’s Dilemma very well. While cooperation could offer more stable, long-term benefits, a lack of trust and coordination may lead firms to prioritise defensive strategies, which can limit collective gains.⁷

Misaligned incentives can result in policies that are effective for individual stakeholders but may not fully support broader collective goals. As a result, understanding the dynamics of the Prisoner’s Dilemma can offer valuable insights for policymakers seeking to improve coordination and outcomes.

So, how can governments and institutions respond to these strategic challenges?

Institutional design

Effective cooperation often benefits from strong, well-structured institutions that can facilitate coordination and reduce the risk of unilateral action. These bodies help align incentives by setting shared rules and reducing uncertainty about others' actions.

For example, coordination between monetary and financial regulators can support more stable and effective outcomes compared to when policies are developed independently.⁸ Strong institutions can help turn short-term, self-interested decisions into outcomes that benefit the broader economy over time.

Transparency and communication

Open dialogue and shared expectations are important. Policymakers should establish credible commitments, including clear timelines, transparent forecasts, and regular communication, to foster trust. Several studies have shown that in repeated game scenarios, information-sharing fosters cooperation, while limited disclosure can make sustained collaboration more challenging.⁹ Whether in forums like G20 or bilateral fiscal talks, transparency can help bridge the gap between national objectives and collective ambition.

Incentives and enforcement

Well-designed reward-and-punishment systems encourage cooperative behavior and help discourage actions that undermine collective agreements. In a global setting, from climate policy to financial regulation, mechanisms like sanctions, financial assistance, or carbon pricing can significantly improve cooperation over time.¹⁰ For policymakers, this means embedding safeguard clauses in treaties, linking financial support to policy commitments, or deploying fiscal tools that reward joint action.

Macroeconomic challenges rarely arise from isolated or misaligned choices. Instead, they often reflect the deeper challenge of strategic independence, where expectations of others shape each actor’s rational decision. The Prisoner’s Dilemma illustrates why systems designed to promote coordination, alignment, and trust are essential. It is important to look beyond narrow incentives and embrace strategic cooperation to achieve sustainable, optimal outcomes. As economic systems grow more interconnected, the ability to manage these dilemmas will remain important to ensure long-term resilience and shared prosperity.

References

¹ Kenton W. Prisoner's Dilemma: Definition, Example, and Game Theory. Investopedia [Internet]. 2023 Jul 31 [cited 2025 Jun 17]. Available from:https://www.investopedia.com/terms/p/prisoners-dilemma.asp

² Kenton W. Utilizing the Prisoner's Dilemma in Business and the Economy [Internet]. Investopedia; 2023 Nov 21 [cited 2025 Jun 18]. Available from:
https://www.investopedia.com/articles/investing/110513/utilizing-prisoners-dilemma-business-and-economy.asp

³ Holt CA, Roth AE. The Nash equilibrium: a perspective. Proc Natl Acad Sci U S A. 2004 Mar 15;101(12):3999–4002. Available from: https://doi.org/10.1073/pnas.0308738101

⁴ Pareto optimality. Encyclopaedia Britannica [Internet]. 2024 [cited 2025 Jun 18]. Available from:https://www.britannica.com/money/Pareto-optimality

⁵ International Monetary Fund. Policy misalignment and macroeconomic outcomes: Evidence from Hungary 2013–2023 [Internet]. Washington (DC): IMF; 2023 [cited 2025 Jun 18]. Available from:
https://www.elibrary.imf.org/view/journals/018/2023/005/article-A001-en.xml

⁶ Verschoor N. The Prisoner’s Dilemma of the Climate. DuurzameStudent.nl. 2024 Feb 7 [cited 2025 Jun 18]. Available from:https://www.duurzamestudent.nl/2024/02/07/the-prisoners-dilemma-of-the-climate/

⁷ EBSCO. Prisoner’s Dilemma [Internet]. Ipswich (MA): EBSCO Information Services; [cited 2025 Jun 18]. Available from:https://www.ebsco.com/research-starters/social-sciences-and-humanities/prisoners-dilemma

⁸ Cloyne J, Ferreira C, Surico P. Monetary policy when households have debt: New evidence on the transmission mechanism. IMF Working Paper. 2018;2018(235). Available from:
https://www.elibrary.imf.org/view/journals/001/2018/235/article-A001-en.xml

⁹ Blonski M, Ockenfels P, Spagnolo G. Equilibrium selection in the repeated prisoner’s dilemma: Axiomatic approach and experimental evidence. Exp Econ. 2017;20(2):366–393. doi:10.1007/s10683-017-9517-4.

¹⁰ Wang Z, Gao J, Szolnoki A, Perc M. Evolutionary game theory in structured populations: A review. arXiv [Preprint]. 2023 Jan 17 [cited 2025 Jun 18]; arXiv:2301.06472. Available from:https://arxiv.org/abs/2301.06472