Repeated Games

Raphael Boleslavsky
2/10
1
1 Repeated Games
1.1 Introduction
Repeated games are an important (and simple) category of dynamic games. As the name
suggests, repeated games are dynamic games generated by the repetition of some static game
a certain number of times, either nite or innite. On the one hand, repeated games are a
simple class of dynamic because the actions and payos to players stay the same over time;
at the same time, this feature makes repeated games interesting. Any dierences between
the equilibrium outcomes at each stage of the repeated game and the equilibrium outcomes
of the static game must be coming from the fact that there are multiple periods in the
interaction. Lets start with the general setup, and then proceed to several examples.
1.2 The General Setup
Starting with a static game G, called the "stage game." We will construct a new game, which
is the repetition of G for T rounds, where T can be either nite or innite. In each round,
all players simultaneously choose actions from their sets of possible actions inherited from
game G. A player observes the outcome of the stage game before the next round of play.
Players can thus observe all of the past outcomes of the stage game when they choose their
action in any particular round. All of the past outcomes are referred to as a "history" of
the game. Players can choose dierent actions in the stage game depending on the history
of play up to that point in the repeated game. A strategy for a player is therefore a plan
which species a particular action of the stage game for each possible history of play. Taking
account of all players strategies determines a sequence of outcomes that occur in each stage
of the repeated game. Each of these outcomes is associated with a payo for each player.
Suppose it is period k T .The strategies chosen by all players leads to a sequence of payos
(u
k
; u
k+1
; :::; u
T
) for a given player The players payo in the repeated game in period k is
u
k
+ u
k+1
+
2
u
k+2
+ ::: +
Tk
u
T
In other words, a players payo is the "discounted" sum of the stream of payos from the
stage game, with payos that are received in the future "reduced" by a factor of < 1. There
are two equivalent ways to think of this ; the rst is as a representation of "impatience."
Typically, if I were willing to pay some money to get some benet in the future, I would
be willing to pay more for that benet today. Conversely, a monetary payo today can be
invested at the risk free interest rate, until next year. Therefore the same amount of money
received next year is worth less today than that same amount of money received today.
2
1.3 Example: Twice Repeated Prisoners Dilemma
Recall the prisoners dilemma game from the rst lecture:
Player 2
Player 1
C S
C 5; 5 0; 12
S 12; 0 1; 1
in this game C is a dominant strategy for both players, and this game has a unique Nash
Equilibrium (C; C) worse for either player than (S; S).
Lets consider a new game: the repetition of this game two times. A strategy for each player
species and action in the rst period, and an action in the second period for each of the
four possible outcomes in the rst period.
A sample strategy (chosen completely arbitrarily) for player 1 is
Period 1: Play S
Period 2:Play S if (S; S) otherwise play C
If both players adopt this strategy, in period one the outcome will be (S; S) leading to a
payo of (1; 1) for either player in period one. In period 2, the strategy dictates that
each player will play S again, leading to a payo of (1; 1). The period one payo to each
player is just the payo in period one, plus times the anticipated payo in period 2.
1 + (1)
3
1.4 Subgame Perfect Nash Equilibrium
Continuing the previous example. we are interested in Subgame Perfect Nash Equilibrium
in repeated games. Remember, "Subgame Perfect" means, simply, that players are only
allowed to use strategies that are credible. No player can claim that they will do something
in the future in response to an action taken today that would not be in the players interest
if he or she actually had to take the action. Formally, we said that for a Nash Equilibrium
to be subgame perfect, it has to form a Nash Equilibrium in every subgame. The twice
repeated Prisoners Dilemma has 5 subgames, as illustrated in the gure above: the entire
game and the second period stage game following each of the four outcomes in period one;
each of these period two subgames is identical to the stage game. Lets start with the period
two subgames. In each of these subgames, we have to have a Nash Equilibrium. Because
the Nash Equilibrium of the Prisoners dilemma is unique, the SPNE strategies must specify
that each player confess in period two. Therefore, no matter what happened in period one,
SPNE requires that each player play C in period two. In the period one game, each player
anticipates that no matter what they do (or what outcome occurs in period one) in period
two, each player will play C, leading to a period two payo of 5: The Subgame starting in
period one therefore looks to each player to be
Player 2
Player 1
C S
C 5 5; 5 5 5; 12 5
S 12 5; 5 1 5; 1 5
In other words, every cell of this table just has (5) added to it. This doesnt change any of
the preference relationships between any of the outcomes, and C is still a dominant strategy
for both players. In period one, then each player will play C. We found that the only SPNE
of the twice repeated prisoners dilemma is for each player to use the following strategy:
Period 1: Play C
Period 2: Play C no matter what outcome happened in period one
That is, each player plays her dominant strategy in every period no matter what the history.
In the last period, the only credible outcome is the Nash Equilibrium of the stage game. This
means that no matter what happens in period one, the payo that each player anticipates
in period two is the same. Therefore, period two is irrelevant from period ones perspective,
and the only possible Nash Equilibrium in period one is for each player to confess. This
same exact logic holds whenever the 1) stage game has a unique Nash Equilibrium (pure or
mixed) and 2) the game is repeated a nite number of times. This leads to the following
concept, known as unravelling
Unravelling: Consider a game G with a unique Nash Equilibrium. The only
subgame perfect Nash Equilibrium of a nite repetition of G is for each player
to play her piece of the unique Nash Equilibrium in every period, regardless of
the history.
4
Both the assumption that the Nash Equilibrium of the stage game is unique and the as-
sumption that the game is repeated a nite number of times is important for unravelling.
When either of these conditions is not met, there can be SPNE that do not unravel.
Multiple Nash Equilibria of the Stage Game.
Lets relax the rst condition, while leaving the second condition intact. Lets look at this
in the context of a simple example: take the Prisoner Dilemma game given above and add
another strategy P, for punish:
Player 2
Player 1
C S P
C 5; 5 0; 12 16; 10
S 12; 0 1; 1 16; 10
P 10; 16 10; 16 13; 13
It is a simple matter to check that (P; P) is also a Nash Equilibrium of the Stage game; the
stage game has two (pure strategy) Nash Equilibria (C; C) and (P; P). The twice repeated
version of this game has ten subgames, the two period game itself, and one subgame for each
of the nine outcomes in period one. As before, subgame perfection requires that in each
period two subgame, the strategies constitute a Nash Equilibrium. In the previous example,
the Nash Equilibrium was unique, so this requirement completely determined the period two
actions after every history. In this case, this requirement tells us only that in every period
two subgame, a SPNE must specify that each player plays either C or P.
In a nitely repeated setting with a unique NE, the only possibility was to repeat the NE
over and over; no cooperation is possible. Is this still true with multiple NE of the stage
game? Can we sustain cooperation in period one by changing play in period 2 depending on
the rst period outcome? Lets think about the following strategy for each player:
Period 1: Play S
Period 2: Play C if (S; S) in period 1, otherwise play P
In period 2, players play either (C; C) or (P; P), so in all period 2 subgames, strategies form
a Nash Equilibrium. We have to check whether this strategy is a Nash Equilibrium in the
rst period game These strategies mean that the rst period game looks like this:
Player 2
Player 1
C S P
C 5 13; 5 13 13; 12 13 16 13; 10 13
S 12 13; 13 1 5; 1 5 16 13; 10 13
P 10 13; 16 13 10 13; 16 13 13 13; 13 13
This game corresponds to the stage game, with 13 added to every cell except (S; S).
The 13 represents the period one "discount" of period two payo from outcome (P; P),
which (given the strategies) occurs whenever the outcome in period one diers from (S; S).
However, following (S; S) players play (C; C), which leads to a discounted period one payo
5
of 5. Given the strategies in period 2 and the strategy of the other player, the payo to
playing S in period one is 1 5; a 1 today, followed by 5 tomorrow. If a player were
to deviate today, the best deviation that a player could make would be to play C in period
one, giving them a payo of 0 in period one, but leading to 13 in period two. In order for
(S; S) to be the Nash Equilibrium in period one, it must be that
1 5 13

1
8
If
1
8
the proposed strategies are a SPNE of the twice repeated game. In equilibrium,
the cooperative outcome (S; S) will happen in period one, even though it is not the Nash
Equilibrium of the stage game! Unlike the case with a unique Nash Equilibrium of the stage
game, when there are multiple Nash Equilibria in the stage game, by varying which NE is
played in dierent subgames it is possible to sustain cooperation in period one.
Innite Repetition
In the case of innite repetition, even if the stage game has a unique Nash Equilibrium, we
obtain a similar result. I will explain the idea in the context of an example rst, then give
a more general explanation.
1
Consider an innite repetition of the same prisoners dilemma that we have been discussing.
C S
C 5; 5 0; 12
S 12; 0 1; 1
Suppose each player uses the following strategy
Period 1: Play S
Periods 2,3,...:
Play S if in all previous periods (S; S) was the outcome
otherwise, play C
In words, the strategy calls for a player to stay silent, provided all players have been silent
in all previous periods. If any player ever confesses, then in all future periods all players
always confess In order for these strategies to be a Subgame Nash Equilibrium, they must
form a Nash Equilibrium in every subgame. In this example, there are really only two kinds
of subgames. In one kind of subgame, a player has confessed in the past; in the other, no
player has ever confessed.
Suppose a player has confessed in the past. The strategy calls for every player to play C in
every period from then on. Because C is a Nash Equilibrium of the stage game, if a player
anticipates that the other player is confessing in every period, the players best response must
be to also confess in every period. Hopefully, you agree that in subgames that follow a play
of confess at any point in the past, playing confess forever constitutes a Nash Equilibrium.
1
In this section I will be a little bit less technical
6
We should also check that the strategy in those subgames in which no player has ever played
C also constitutes a Nash Equilibrium. Suppose a player anticipates that the other player
will follow this strategy, and is deciding whether to play S or C in a certain period. If a
player decides to play S, he will get a payo of 1 today. Because he thought it was a good
idea to play S today, he will also think it is a good idea tomorrow, so he anticipates that he
will get a payo of S tomorrow, and in every period thereafter, leading to a payo of
1 + (1) + (1)
2
+ ::: = (1)
1
1
Suppose the player decides that S isnt a good idea, and it is better to play C today. The
other player is playing S, which means that by confessing today, the player has a payo of 0
instead of 1. Starting tomorrow, however, the strategy dictates, that every player should
play C, leading to a payo of 5, starting tomorrow and going forever. The players payo
from playing C is therefore
0 + (5) +
2
(5) + ::: = 0 + (5)

1
In order for staying silent to be the players decision, (i.e. for the strategy to be a subgame
perfect Nash Equilibrium) it should be that
(1)
1
1
0 + (5)

1
1 5

1
5
Hence, if
1
5
, the proposed strategies constitute a Subgame Perfect Nash Equilibrium.
More generally, suppose that some outcome (a
1
; a
2
; :::; a
N
) is a Nash Equilibrium of the stage
game, but some other outcome (a

1
; a

2
; :::; a

N
) is better for every player than (a
1
; a
2
; :::; a
N
) :
Suppose the players all agree to play (a

1
; a

2
; :::; a

N
) : Because (a

1
; a

2
; :::; a

N
) may not be
a Nash Equilibrium in the stage game, each player may have an incentive to deviate at
every stage. However, if any player deviates, then the agreement calls for every player to
play their part of the Nash Equilibrium for ever after, so that in every period the out-
come is (a
1
; a
2
; :::; a
N
). In every future period the outcome is worse for the deviating player
than (a

1
; a

2
; :::; a

N
). If is big enough, the punishment of losing the dierence between
(a

1
; a

2
; :::; a

N
) and (a
1
; a
2
; :::; a
N
) in every period will outweigh the gain from cheating on the
arrangement today. So for big enough the strategies
Period 1: Play a

i
Periods 2+:
Play a

i
if in all previous periods (a

1
; :::a

N
)
otherwise, play a
i
will be a Subgame Perfect Nash Equilibrium. Even though, a

i
is not a Nash Equilibrium
of the stage game, in the innitely repeated game we could observe this outcome in every
period.
7
2 Examples and Application
2.1 Collusion in Models of Firm Competition
In a one-period setting, collusion is typically not a Nash Equilibrium. However, as we have
seen, in repeated settings, outcomes that may not be Nash Equilibria of the stage game can
actually arise as part of an equilibrium in a dynamic game.
Cournot Game:
In the Cournot game , if the rms try to collectively act as a monopolist, prices will be set
so high that each rm will have an incentive to "overproduce" to take advantage of the high
prices. Indeed, recall the standard Cournot game:
P = 1 Q
u
i
(q
1
; q
2
) = (1 q
1
q
2
) q
i
q

i
=
1 q
j
2
Using this best response function, it is easy to nd the monopoly quantity. With a single
rm, that rm plays its best response to a quantity of zero by the other rm. The monopoly
quantity is therefore
1
2
(leading to a prot of
1
4
). Suppose the rms try to collude, so that
each rm produces half of the monopoly output,
1
4
, and then the rms split prots equally,
generating a prot of
1
8
for each rm. It is easy to verify that the best response to
1
4
, however,
is not
1
4
but
3
8
. In order for the collusive scheme to work, the rms have to observe each others
outputs, and more importantly, punish each other for deviations from the prescribed outputs.
These kinds of punishments lead to behaviors that are potentially detectable by a regulator,
and, since collusion is generally illegal, could lead to severe sanctions and punishments by
the government.
In a repeated game, however, the total future payo to collusion (over competition) can
create an incentive for the rms NOT to cheat on the collusive arrangement in any given
period. Suppose the rms play the type of strategy described previously:
Period 1: Produce
1
4
Periods 2+:
Produce
1
4
(half monopoly) if in all previous periods the total output was
1
2
otherwise, produce
1
3
(Cournot output)
In the current model, the payo to collusion for each rm is
1
8
, while the payo to Cournot
competition is
1
9
. We found that, if one rm colludes, producing its share of the monopoly
output
1
4
, the other rm has an incentive to produce
3
8
, leading to a prot of
_
1
1
4

3
8
_
3
8
=
9
64
in the current period. If the cartel member sticks to the arrangement,
_
1
8
_
1
1
8
If she cheats,
9
64
+
1
9

1
so as long as
_
1
8
_
1
1

9
64
+
1
9

1

9
17
Collusion is the outcome in every period in the subgame perfect Nash Equilibrium of the
innitely repeated game.
Bertrand Game
Suppose two rms with production costs of zero operate in a market of size 1. The rm
that sets the lower price captures the entire market, the other rm has no sales, and earns
a prot of zero. If the two rms set the same price, they split the market equally.
2
In the
static version of this game, there is only one Nash equilibrium in pure strategies, p
1
= p
2
= 0
which brings each rm a prot of zero, (there are also an innite number of mixed strategy
equilibria, one for each possible prot level, but lets conne attention to pure strategy
equilibria). In an innitely repeated game, the rms could try to agree on a price that
they would both set, splitting the market equally and earning positive prot. Of course, if
one rm anticipates that the other rm will post a positive price, it will have an incentive
to undercut that rm by a small amount, capturing the entire market. If it does so, the
agreement will fall apart, leading to a payo of zero forever, so for values of high enough,
collusion can be supported in a subgame perfect equilibrium.
Consider the following strategies:
Period 1: Charge price p
Periods 2+:
Charge price p provided the price was p in all previous periods
otherwise, charge p = 0
If the rm sticks to this arrangement the rms both charge p and each rm earns
p
2
in each
period leading to a prot of
p
2
1
1
If the rm deviates, it has an incentive to undercut slightly, giving it a prot of p " which
is just about p; but by doing so, it sacrices all future gains from collusion, inducing the
competitive outcome in all future periods. The gain to doing so is therefore just p. It follows
that, provided
p
2
1
1
p

1
2
2
This is actually identical to the Strawberry Festival Problem in Homework 2.
9
The strategies constitute a SPNE, and the rms will collude in every period in equilibrium.
2.2 Establishing a Reputation
Long lived relationships can provide additional incentives for individuals to engage in dif-
ferent types of behavior, not present in short lived relationships. In some cases, we have a
word for the mechanism by which these incentives operate: we call it a "reputation." Lets
think about the following example. A grape farmer has a business relationship with a large
vineyard. Every so often, the farmer supplies grapes to the vineyard, and the vineyard makes
a payment to the farmer. Of course, the grapes can vary in quality, depending on the care
and eort of the farmer, and the vineyard can oer dierent prices for the grapes. However,
it may be dicult for the vineyard to observe the quality of the grapes prior to purchase.
To model this as a simultaneous move game, suppose that the farmer chooses the quality
of the grapes, q 2 [0; 1]; without observing the quality of the grapes, the vineyard makes a
payment p to the farmer. The payos are as follows
u
F
(q; p) = p qc
u
V
(q; p) = qv p
With these payos, u
V
+ u
F
= q (v c). Provided v c trade between the farmer and the
vineyard is good from a collective perspective. Assume therefore, that v > c. If this were
a simultaneous move game, however, both parties have dominant strategies: regardless of
what price the farmer is paid, he has an incentive to make q = 0, i.e. produce the low quality
grapes. Similarly, regardless of what quality grapes the farmer produces, the vineyard has
an incentive to set p = 0, i.e. pay nothing. What happens in a long-lived relationship, i.e.
in an innitely repeated game?
Suppose the farmer and vineyard plan to cooperate. In this case, cooperation means that
the vineyard oers p = p

and the farmer produces q = 1. In order to support this as the

outcome, the players use the following strategies
Farmer
Period 1: Produce q = 1
Periods 2+:
Produce q = 1 provided q = 1; p = p

in all previous periods

otherwise, produce q = 0
Vineyard
Period 1: Pay p = p

Periods 2+:
Pay p = p

provided q = 1; p = p

in all previous periods

otherwise, pay p = 0
Following any deviation from the cooperative outcome, the players plan to play the static
Nash Equilibrium forever, giving each a payo of zero. This can be interpreted as a break-
down in the relationship. If the farmer produces q = 1 in exchange for a payment of p

, the
farmer gets a payo of p

c in each period. If the farmer decides to cheat, he will produce

q = 0, in exchange for a payment of p

, but from the next period on, the relationship will

10
break down, leading to a zero payo in all future periods. In order for it to be subgame
perfect for the farmer to stick to the agreement, it must be that
p

c
1
p

Provided the price is larger than

c

it is credible for the farmer to claim that he will produce

the good quality grape.
If the vineyard pays p

, the vineyard anticipates that it will buy high quality grapes in each
period, leading to a payo of v p

in each period of the interaction, but if it cheats, and

pays p = 0 in some period, it will get high quality grapes in that period for free, but the
relationship will break down in the future. Therefore, provided
v p

1
v
p

v
Therefore, for any price
c

v
the proposed strategies constitute a SPNE. In order for such a p

to exist, it must be that

v
c

c
v

_
c
v
If v > c then you can always nd close to one that will make this condition hold. If you
think of as the "impatience" associated with delaying a future payo, then it is intuitive to
think that if you reduce the time that the individual has to wait, increases. My impatience
cost of waiting a week is much higher than the cost of waiting an hour. Therefore, if the
farmer and the vineyard can transact frequently enough, then the strategies we found form
a SPNE.
Lets look again at the conditions that we found. For the farmer to produce the high quality
grape, it had to be that p

. The farmers cost of producing the high quality grape, is

only c. So the farmer is earning a prot of
c

c. You can think of this prot as the farmers

"reputation premium." In this equilibrium the farmer has a "reputation" for producing high
quality grapes, and therefore commands a premium above cost. The vineyards constraint
meant that the price the vineyard pays must be less than v. The vineyard therefore must
get a minimum payo of (1 ) v. This minimum payo can be interpreted as the gain to
the vineyard from maintaining a reputation for "honest dealing."
11
2.3 Exchanging Favors
Reciprocal altruism is a social norm that is common to many cultures. In this section we
will analyze reciprocal altruism in an employment setting.
Consider a simple economy that has two workers. Each worker has a probability of p of
being employed in each period. I the worker is employed she earns a wealth of w at her job.
If she is unemployed she has no wealth. If a worker has a wealth of w, her payo is
u(w) =
p
w
0 1 2 3 4 5
0.0
0.5
1.0
1.5
2.0
w
u(w)
If a worker is employed, her wealth is 100; if she is unemployed her income is 0. Suppose
initially that there is only one period. After learning whether is employed or not, an employed
worker can contribute an amount c
i
to the other worker, if the other worker is unemployed.
If the government could mandate that workers contribute to maximize the expected total
payo of both workers, what contribution levels would the government choose? The only
cases in which contributions have any eect on the total payo is in the case when one worker
is employed and the other isnt. In this case, the government would choose the contribution
of the employed worker, c
E
in order to maximize the total payo of the workers.
max
c
E
_p
100 c
E
+
p
c
E

The rst order condition for this problem is just given by

d
dc
E
_p
100 c
E
+
p
c
E
_
= 0
1
2
p
c
E
p
100 c
E

p
c
E
p
100 c
E
= 0
p
100 c
E

p
c
E
= 0
c
E
= 100 c
W
c
E
= 50
12
If it could, the government would mandate a contribution which would make the workers
wages equal no matter who is employed. If both are employed or unemployed then they get
the same wage, 100, but if one is employed, he is required to give half of his wage to the
other worker, leaving both with a wealth of 50.
Now lets say that the government is not in a position to enforce compliance with this
program, so any contributions are purely voluntary. In any Nash Equilibrium of this con-
tribution game, each employee has a dominant strategy to contribute zero. After all, an
employed individuals payo is simply
u
E
=
p
100 c
E
Of course, the employed individual recognizes that if the situation were reversed, he might
receive something from the other worker, but this doesnt aect his payo from contributing
c
E
. The only time that the contribution levels matter to player 1 is when either he is con-
tributing, or he is receiving a contribution. When he receives a contribution it is determined
by player 2s action, not his own. His action only determines how much he contributes when
2 is unemployed. No matter how much player 1 anticipates two will contribute, player 1 has
an incentive to contribute as little as possible, i.e. zero. The expected payo of a worker if
there are no contributions is just
10p
the probability he is employed, multiplied by his payo from his full wage,
Now lets imagine that this game is repeated an innite number of times. Is it possible
for workers to exchange favors in the collectively best possible way, contributing half their
income if he is employed and the other is unemployed? Suppose that each worker uses the
following strategy.
Period 1: Contribute c = 50 if employed and other worker unemployed
Periods 2+:
Contribute c = 50 if employed and other unemployed
provided in all previous periods, if one employed and other not
employed worker contributed 50.
If not, contribute c = 0
If a worker follows the agreement, contributing 50 whenever the other worker is unemployed,
then his expected payo, before he knows whether or not he is employed, is given by:
10p
2
+ 2p (1 p)
p
50
The rst term gives the workers payo when both workers are employed; the second term
represents the workers payo when only one is employed (notice, it doesnt matter which
worker is employed, both workers receive payo
p
50 = 5
p
2). If a worker is employed, and
the other worker is unemployed, his expected payo from following the strategy is
p
50 +

1
_
10p
2
+ 2p (1 p)
p
50
_
The
p
50 is the workers payo today from doing the favor; this preserves the agreement
to exchange favors, forever after. On the other hand, if the worker does not contribute, he
13
benets in the current period, as he enjoys his entire income, but he will never again receive
a favor from the other player. The payo to doing this is
10 +

1
10p
In order for maintaining the exchange of favors to be a SPNE, it must be that
p
50 +

1
_
10p
2
+ 2p (1 p)
p
50
_
10 +

1
10p
p
50 = 5
p
2

1
_
10
p
2
_
p p
2
_
10
_
p p
2
_
_
10 5
p
2

1
_
10
_
p
2 1
_
p (1 p)
_
10 5
p
2

1
(p (1 p))
10 5
p
2
10
p
2 1
10 5
p
2
10
p
2 1
= k

1
p (1 p) k

k
k + p (1 p)
: Therefore, for any given value of p, the probability of being employed, there is a suciently
large value of < 1 for which the exchange of favors is a subgame perfect equilibrium
14
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
p
y
In the previous plot, the curve is a graph of function
k
k+p(1p)
. If is above this function,
then for that value of p, exchange of favors is a subgame perfect equilibrium. Interestingly,
When p is close to 1 or 0 exchange of favors is more dicult to maintain. If p is close to
one, then future cooperation isnt very valuable because each player will be employed most
of the time anyway. If p is close to 0, exchange of favors isnt valuable because the other
player is unlikely to have an opportunity to return the favor in the future. Would it make
sense to give someone half your lottery winnings in exchange for the opportunity to receive
half of his lottery winnings, if he happens to win the lottery someday?
2.3.1 Imperfect Monitoring
The previous analysis assumes that if one player is employed, the other player knows it:
therefore, a worker always knows if the other failed to share his income. Suppose, however,
that a worker doesnt always know whether the other worker is actually employed. Imagine
that employed workers all meet for lunch in the oce cafeteria. If you see the other worker
at the oce you know that he is employed and there is no need to send him any income. If
you dont see him there, you know that you are supposed to send him some income under the
exchange of favors agreement. However, if the other worker isnt at the oce, he wont know
for sure that you were at the oce either; therefore you have a chance to withhold the favor
you owe, without being caught. Suppose that with probability q the unemployed worker
learns that the employed worker actually did work, but with probability 1 q he doesnt
learn anything about whether the other worker was employed. Of course, if the other worker
provides him with some income, he knows for sure that he was employed, but if he did not
receive income because the other guy was employed but cheated, he wont know for sure,
but only with probability q.
In this case, all of the previous analysis is the same, except that the payo to cheating is a
bit dierent. Instead of cheating being discovered for sure, cheating is only discovered with
probability q. Therefore a worker may still cheat and have a chance of keeping his reputation
15
for exchanging favors.
If the worker does not contribute, he benets in the current period, as he enjoys his entire
income, but with probability q, he will be discovered and will never again receive a favor from
the other player with payo 1 q the deception will remain secret. The payo to cheating
is therefore
10 +

1
_
q
_
10p
2
_
+ (1 q)
_
10p
2
+ 2p (1 p)
p
50
__
recreating the previous analysis gives:
p
50 +

1
_
10p
2
+ 2p (1 p)
p
50
_
10 +

1
_
q
_
10p
2
_
+ (1 q)
_
10p
2
+ 2p (1 p)
p
50
__

1
q
_
10
p
2p (1 p)
_
10 5
p
2

1
qp (1 p) k

k
k + qp (1 p)
Thus everything is pretty similar, except that q < 1 requires a higher value of for the
agreement to be sustainable. In the following picture, the black curve represents q = 1, blue
is q = 0:8, and red is q = 0:5
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
p
y
16