game theory, prisoner’s dilemma, non-zero-sum game, software industry, contract compliance, contract behaviour, NCR, BCP, data warehouse, cooperation, strategy, business strategy, last-round strategy

1. Game Theory
“Prisoner’s Dilemma in the
Software Industry”
by Peter Louis and Nikolas Kelaiditis
November 2001
© 2001 Peter Louis & Nikolas Kelaiditis. All Rights Reserved Page 1 of 9

2. Abstract:
This paper shows that the Prisoner’s Dilemmas problem exists in real business
situations. As an example, the software industry is depicted, namely the case
of National Cash Register (NCR) developing software for BCP Telecomuni-
cações, a Bell South company, in Sao Paulo. It will be demonstrated that both
NCR and BCP have an incentive to defect in order to maximize their benefit in a
single-phase game. It will become apparent, however, that this behavior, like in
the classical Prisoner’s Dilemma, will lead to a Nash Equilibrium that is
suboptimal for both parties and that it is in the best interest of NCR and BCP to
cooperate, allowing them to achieve a mutually beneficial outcome. It will then
be further demonstrated that a multi-phased project is a possible way of solving
this problem (meaning to reduce the incentive to behave uncooperatively to a
minimum). Here, each project phase corresponds to a round in a Prisoner’s
Dilemma with the optimization of each phase, as a whole, providing the
incentive to continue the iterative game with the “Tit For Tat” strategy being
used by both parties to achieve the an optimal solution.
Game Theory:
We live in a society where people do not always act the right, moral way but
sometimes tend to look after themselves and their own interests first. In some
situations, persons seek to maximize their benefit at the expense of others.
Therefore, there is little incentive to cooperate, to improve the outcome of both
parties. However, cooperation does occur and is a feature of our society.
Hence, how does cooperation develop when each individual has the incentive
to be selfish and not cooperate?
In game theory, cooperation is usually analyzed by way of a non-zero-sum
game called the “Prisoner’s Dilemma”1 A "zero sum" game is a win-lose game
such as tic-tac-toe. For every winner, there is a loser. In contrast, non-zero
sum games allow for cooperation.
1
Axelrod 1984
© 2001 Peter Louis & Nikolas Kelaiditis. All Rights Reserved Page 2 of 9

3. In a Prisoner’s Dilemma, the two players have the choice between two moves,
either "cooperate" or "defect". The idea is the following: each player gains
when both cooperate, but if only one of them cooperates, the other one (who
defects) will gain more. If both defect, both lose (or gain very little) but not as
much as the "cheated" cooperator whose cooperation is not returned.
The classical Prisoner’s Dilemma describes a hypothetical situation whereby
two criminals are arrested under the suspicion of having committed a crime
together. However, the police do not have sufficient proof in order to convict
them. The two prisoners are isolated from each other, and the police visit each
of them offering the following: the one who offers evidence against the other
one will be freed. If none of them accepts the offer, i.e. they are cooperating
against the police, then both of them will get only a small sentence because
they have insufficient proof. They both would gain. However, if one of them
betrays the other by confessing to the police, the defector will gain more, since
he will be set free; the one who remains silent, on the other hand, will receive
the full sentence, as he did not assist the police, and there is adequate proof. If
both betray, both will be sentenced, but less severely than if they had refused to
talk. The dilemma occurs because each prisoner has a choice between only two
options, but cannot make a good decision without being aware of what the other
intends to do.
Such a distribution of gains and losses appears to be natural in many situations,
since the cooperator whose action is not reciprocated will lose resources to the
defector, without either one being able to collect the additional gain coming from
the synergy of their cooperation.
In a non-zero-sum game, the player's interests are not completely opposed.
Rather, the possibility of achieving a mutually beneficial outcome exists. The
problem with the prisoner's dilemma is that if both decision-makers were entirely
rational, they would not cooperate. Indeed, rational decision-making means
that you make the optimal decision for you regardless of what the other actor
decides. Assume the other one would defect, then it would be rational to defect
as well: you will not gain anything, but if you do not defect, you will end up with
a loss. Suppose the other one would cooperate, then you will gain, but not as
© 2001 Peter Louis & Nikolas Kelaiditis. All Rights Reserved Page 3 of 9

4. much as you would if you decided not to cooperate - so here too the rational
choice is to defect. The problem is that if both actors are rational, both will
defect, and none of them will gain anything, ending up in a so-called Nash
Equilibrium2. Nevertheless, if both would "irrationally" decide to cooperate, both
would gain. This paradox can be formulated more explicitly through the
principle of suboptimization: optimizing the outcome for a subsystem will
generally not optimize the outcome for the system as a whole. In the classical
prisoner’s dilemma, the suboptimization for each of the prisoners separately is
to betray the other one, but this leads to both of them being sentenced rather
severely, while they might have gone away with a mild sentence if they had
stayed silent.
By playing a Prisoner’s Dilemma situation a repeated number of times, each
party is given the possibility to adapt its decision to the counterpart’s one and
thus reach a more optimal solution as the incentive for defecting is reduced.
For instance, if we could play the classical Prisoner’s Dilemma a few times, we
would try to figure out our counterpart’s strategy and use it to minimize our own
total jail time. We could pursue several different strategies:
• The Golden Rule - "Do unto others as you would have them do unto
you." Always cooperate (don't confess). This rule would theoretically lead
to the optimal outcome, but if our counterpart acts rationally, he will
always defect, maximizing our jail time.
• Tit For Tat - "Do unto others as they do unto you."
Begin with a defection (confess) for the reasons described in the above
section, but after that do whatever our counterpart did last. However, in
many real-life situations (e.g. business), then to start by not confessing
would be preferable.
• Tit For Tat 3 - Almost the same as the Tit For Tat rule. The exception is
that we are a little more forgiving. If the counterpart defects (confesses),
we will forgive him about once every three times and cooperate the next
2
If there is a set of strategies with the property that no player can benefit by changing her strategy while
the other players keep their strategies unchanged, then that set of strategies and the corresponding
payoffs constitute a Nash Equilibrium.
© 2001 Peter Louis & Nikolas Kelaiditis. All Rights Reserved Page 4 of 9

5. time anyway. As with the golden rule, the counterpart to our
disadvantage may exploit this strategy.
• The Iron Rule - "Do unto others as you wish, before they do it unto you."
Always defect. Both parties tend to accumulate a large prison sentence.
• The Random Rule - Randomly choose "confess" or "don't confess."
This strategy is not likely to lead to an optimal outcome as it does not
follow a pattern and thus does not allow a joint strategy.
The Prisoner's Dilemma in Business
Software development is an area where a Prisoner’s Dilemma relationship can
exist, particularly when one party might be more dominant in the relationship
than the other party. For example, consider a data warehouse project where
NCR is looking to create the first major data warehouse in Brazil with the major
mobile operator in Sao Paulo, BCP. The success of this project is critical to
NCR’s fortunes in Brazil and NCR can use it as an example to campaign for
other projects in the industry or other sectors.
NCR intends to develop the data warehouse software for BCP in exchange for
the payment as agreed by the contract. If by the end of the contract, NCR
delivers substandard work or something that does not work according to
specifications or its deliverables are late and BCP pays, then NCR has received
its payment whilst BCP has not received the deliverables as agreed. BCP has
been short-changed.
On the other hand, if NCR meets its contract requirements and produces its
deliverables on time and BCP refuses to pay, then BCP has received the
agreed deliverables as per contract whilst NCR has received either nothing for
its efforts or less than agreed. Defection by BCP might also include requests
for additional functionality at the same price or ambiguous interpretations of
deliverables different from that of the NCR insisting on rework, etc. In essence,
the outcomes have been reversed.
© 2001 Peter Louis & Nikolas Kelaiditis. All Rights Reserved Page 5 of 9

6. However, if both NCR and BCP perform cooperatively, NCR delivers what it has
agreed on time and BCP pays upon receipt of the deliverables, then both
parties will benefit from the relationship. The extent of the benefit, however, is
less if either party decided to take advantage of the other. For example, it will
require more effort and money by NCR to produce the agreed deliverables than
simply to produce poor or non-functional work for the same amount of money
from BCP. If both NCR and BCP both break their agreement then they both
lose with NCR not getting that foothold in Brazil while BCP gets to keep their
money.
If honour was a guarantee of contract conformity, then one could expect
developers to produce all that was agreed, and on time. Similarly, companies,
such as BCP, would pay the full contract price upon receipt of the deliverables.
Unfortunately, this is not the case and the solution that NCR and BCP have
employed to ensure the conformity of the other party and to minimize their risk,
is the multi-phase software contract. Here, deliverables are specified for each
critical stage during the project and payments are made based upon the
completion of phases. This in turn, turns a one-turn prisoner’s dilemma into a
multi-turn game whilst reducing the risks to each party at each phase. At each
phase, each party can determine if the other party has fulfilled their part of the
contract – has their been cooperation. For example, BCP can inspect load
scripts and/or the contents of the data warehouse to ensure compliance before
deciding whether to pay or not. Similarly, NCR can ensure the receipt of
payment before deciding whether to commence the next phase.
Yet, a well-drafted contract also includes provisions to protect the developer to
restrict deliverables to what has been agreed and clearly specified. This
reduces the client’s ability to defect by withholding acceptance. These
provisions are usually required to enforce customer acceptance of the contract
on the last round. Without a provision, a client could holdout for the inclusion of
a modification or “extras” not previously thought of at the cost of the developer.
Even with such a provision, where the number of rounds are known, a client
might choose to defect on the last round if the client believes that he will not
© 2001 Peter Louis & Nikolas Kelaiditis. All Rights Reserved Page 6 of 9

7. have to deal with you again – hoping to keep the balance of the money.
However, a well-drafted contract will limit this occurrence.
As with NCR, it is usually not in the interest of developers to defect and
defection is usually due to negligence not malicious intent. NCR’s prospects in
Brazil, in part, are determined by the success of the project and for this reason
they have ensured that experienced team members were included. Whereas
BCP has less need to play by the rules and can easily find another developer
willing to provide a data warehouse for such an important client.
The most effective strategy for NCR to employ in an iterated prisoner’s dilemma
is a simple “Tit For Tat” one – offering cooperation on the first move and then
echoing (cooperation or defection) what BCP does on their last move. Here
cooperation is rewarded with cooperation whilst defection is immediately
punished with defection. However, NCR, like most developers who are looking
to establish a position in a market or who are in an unbalanced relationship, do
not apply this strategy. This can be due to the need to keep the account happy
or the desire to have additional sales after the contract has been completed.
This approach only encourages BCP to defect.
Given this situation, NCR should be prepared to suspend work on a subsequent
phase given defection by BCP on the current phase. This, however, should
only be done once a review is performed to ensure that NCR was not at fault or
that a misunderstanding did not occur that can be resolved without NCR’s
defection. However, if NCR complied with the agreement on the current phase,
then moving to the next phase in the presence of the defection of BCP is a
sucker’s move.
The IT project is for a known number of phases (therefore the associated
prisoner’s dilemma is for a known number of iterations) and preventing BCP’s
defection on the last round is a difficult problem. The uncertainties at the start
of the project are almost gone as the phases have been completed and the
minor issues resolved. BCP has an almost complete working data warehouse
but can use the issue of minor bugs to withhold payment. The benefit of
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8. retaining the final payment is greater to BCP than the benefit of maintaining a
good relationship with NCR and the prospects of future business. Some
strategies that NCR can use on the last round to encourage compliance by BCP
are:
Use a software activation key to allow full-functionality of the product.
However, this must be clearly stated in the contract and its implications
should be made to the BCP. The correct legal advice should be sought.
In the contract, a clause can be added that only transfers ownership of
the development once the final payment has been made.
Withhold extras until final payment has been received, such as source
code or link libraries that do no inhibit user acceptance testing or product
use, solely new developments.
Acceptance can defined narrowly to almost guarantee acceptance such
that non-payment by BCP will almost certainly lead to legal action with
the result being in the favour of NCR.
The contract could also include additional services or a maintenance
phase that is crucial to the effective operation of the warehouse ensuring
that BCP makes the last payment, as it would be in their best interest to
do so.
As has been demonstrated, the implications of the Prisoner’s Dilemma problem
for the IT industry can be reduced to a series of iterative games in order to
reduce the risk of defection and achieve a more optimal total outcome.
Nonetheless, in the last game, there remains an incentive to defect, which can
be mitigated by employing one or more of the last-round strategies described
above. The solution that has been outlined likely to be equally applicable to
other industries where similar conditions or relationships occur
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9. Exhibit 1: Classical Prisoner’s Dilemma
Prisoner 2
Confess Don’t Confess
Confess 5, 5 0 , 10
Prisoner 1
Don’t Confess 10 , 0 2,2
Confess / Confess constitutes a Nash Equilibrium.
(the higher the numbers in this matrix, the stricter the sentence, i.e. the players will prefer a
lower number to a higher one)
Exhibit 2: NCR vs. BCP
BCP
Pay Don’t Pay
Good Code 3, 3 0,5
NCR
Bad Code 5,1 1,2
Deliver a bad code / Don’t pay constitutes a Nash Equilibrium.
(the higher the numbers in this matrix, the higher the utility, i.e. here the players will prefer a
higher number to a lower one. Furthermore, it is assumed that a bad code will have some utility
for BCP, and that delivering a bad code is dominant over delivering a good one due to lower
development cost)
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