Department of Economics

We study experimentally a two-stage compensation mechanism for promoting cooperation in prisoner’s dilemma games. In stage 1, players simultaneously choose binding non-negative amounts to pay their counterparts for cooperating in a given prisoner’s dilemma game, and then play the prisoner’s dilemma game in stage 2 with knowledge of these amounts. For the asymmetric prisoner’s dilemma games we consider, all payment pairs consistent with mutual cooperation in subgame-perfect equilibrium transform these prisoner’s dilemma games into coordination games, with both mutual cooperation and mutual defection as Nash equilibria in the stage-2 game. We find considerable empirical support for the mechanism, as cooperation is much more common when these endogenous transfer payments are feasible. We identify patterns among transfer pairs that affect the likelihood of cooperation. Mutual cooperation is most likely when the payments are identical; it is also substantially more likely with payment pairs that bring the payoffs from mutual cooperation closer together than with payment pairs that cause them to diverge. There is substantial scope for this compensation mechanism to achieve beneficial social outcomes in commerce and in international affairs, and reason to be concerned about the ability of firms to design collusive agreements.