Department of Economics

This paper considers self-stipulated penalties for defection and rewards for cooperation as inducements to cooperate in the prisoner's dilemma. The paper explicitly characterizes penalties and rewards that are necessary and suffcient to induce the players to cooperate. The characterization results imply a partion of prisoner's dilemma games into four classes according to whether both penalties and rewards can induce the players to cooperate; penalties but not rewards can induce the players to cooperate; rewards but not penalties can induce the players to cooperate; and neither penalties nor rewards can induce the players to cooperate. The paper also discusses implications of the results to "penalty clauses" in the law of contracts.