4.3 Different approaches to corporate governance  (Page 4/9)

Options for the prisoners

• If both A and B confess . A and B are put in jail for five years each. The net loss in this scenario is 10. This is the least desirable alternative from the collective standpoint.
• If one confesses and the other does not . The confessor is released immediately while the non-confessor gets seven years in prison. This maximizes the confessor's self interest but severaly punishes the patriotic, non-confessor. Net loss is 7.
• If both do not confess . After six months of half-hearted interrogation (most of this time is for processing the prisoners' release), both are set free for lack of evidence. While not maximizing self interest (this lies in confessing while the other remains silent) this does maximizes overall welfare by producing a net loss of only 1.

Assumptions in the prisoner dilemma

• Cooperation produces the best collective option and the second best individual option. This, in turn, assumes that cooperation produces more social welfare than competition.
• Free riding (competing) on the cooperation of others produces the most individual gains (for the free rider) but the second worst collective results. Society suffers loses from the harm done to the trusting, non-confessor and from the overall loss of trust caused by unpunished free-riding.
• Unlimited, pure competition (both prisoners confess) produces the worst collective results and the second worst individual results.
• Multiple iterations of the prisoner's dilemma eventually lead to cooperative behavior. But what causes this? (1) The trust that emerges as the prisoners, through repeated iterations, come to rely on one another? Or (2) the fear of "tit-for-tat" responses, i.e, that free riding on the part of one player will be punished by free riding on the part of the other in future iterations?
• Does the Prisoner's Dilemma assume that each player is a rational, self-interest maximizer? Are the players necessarily selfish in that they will seek to maximize self interest even at the expense of the other players unless rewards and punishments are imposed onto the playing situation from the outside?

The Prisoner's Dilemma is designed to model the reality of corporate governance where the directors/owners of a corporation delegate responsibility for the corporation's operations to managers who are charged with pursuing, not their own interests, but those of their directors. The problem of corporate governance is how this cooperative arrangement is institutionalized. Can managers be left alone and trusted to pursue the best interests of the corporation? This is implied in stewardship theory. Or is it necessary to design a system of controls to keep the managers from diverting the operations of the corporation toward their exclusive, self-interests? This is the approach taken in agency theory. Modeling this in terms of repeated iterations of the prisoner's dilemma, does cooperation emerge as the most reliable strategy in the long run? Or does it need to be manufactured by introducing a system of incentives such as fear of tit-for-tat strategies? The Prisoner's Dilemma models the central problems of corporate governance by asking whether cooperation naturally emerges between managers and directors or whether it needs to be manufactured through a system of punishments and rewards.