Hidden Actions

Cheaters flourish in shadows. Hidden actions in a repeated prisoners’ dilemma game increase the chances of betrayal. In all simultaneous move games you make your move before you know what strategy your opponent will employ this round. In studying repeated prisoners’ dilemma games, however, we have previously assumed that the other player can see your move after you make it. This means, for example, that if you cheat in round five, your opponent will realize you betrayed him before he makes his move in round six. Sometimes, however, a player does not notice an opponent’s move until long after it has been played.

What if it would take your opponent 10 rounds to figure out you had betrayed him? You would have a massively increased incentive to cheat, for now you could exploit him for 10 rounds before he would have a chance to retaliate.

OPEC’s Hidden Action Problem

Hidden actions drain the strength of OPEC, a cartel of the world’s major oil-producing countries. Countries in OPEC agree to limit their production of oil to increase their total oil-exporting profits.

Should an OPEC member like Kuwait restrict its oil production? Obviously, by reducing production Kuwait would sell fewer barrels of oil. Supply and demand governs the world price of oil: the lower the supply of oil, the higher the price. If Kuwait reduces its production of oil, the world supply of oil would shrink, causing the price of oil to increase. The price will decrease, however, regardless of whether Kuwait or Saudi Arabia reduces its production. Kuwait, therefore, would ideally like to sell large quantities of oil while all the other OPEC members cut production. Of course, all OPEC members would like other OPEC countries to be the ones that reduce their oil output.

Recognizing their dilemma, OPEC countries jointly agree that they should all reduce oil production. Each OPEC member, however, has an incentive to cheat. If all the other countries constrain their oil output, then the cheating country could produce a lot of oil while still enjoying the benefits of high world oil prices. Of course, if every country cheats, then the price of oil will plummet. OPEC members are consequently in a repeated prisoners’ dilemma game with no clear last period. For any given period it’s in each individual country’s self-interest to cheat. The reason that a country might not cheat in this period, however, is because if it gets caught, other countries are more likely to cheat in the future. The harder it is to get caught, the more attractive cheating becomes. Because OPEC countries can’t perfectly monitor each other’s output, they frequently cheat by producing more than they agreed to. One of the justifications that Iraq gave for invading Kuwait in the Gulf War was that Kuwait was cheating on its OPEC oil production quota. Oil-importing countries like the United States, of course, benefit when OPEC members cheat.