Lecture 22 - Repeated Games: Cheating, Punishment, and Outsourcing

In business or personal relationships, promises and threats of good
and bad behavior tomorrow may provide good incentives for good
behavior today, but, to work, these promises and threats must be
credible. In particular, they must come from equilibrium behavior
tomorrow, and hence form part of a subgame perfect equilibrium
today. We find that the grim strategy forms such an equilibrium
provided that we are patient and the game has a high probability of
continuing. We discuss what this means for the personal
relationships of seniors in the class. Then we discuss less
draconian punishments, and find there is a trade off between the
severity of punishments and the required probability that
relationships will endure. We apply this idea to a moral-hazard
problem that arises with outsourcing, and find that the high wage
premiums found in foreign sectors of emerging markets may be
reduced as these relationships become more stable.