[MUSIC] Let's now see a very interesting aspect of interaction between the firms, in particular what happens when the agreement breaks down. Because this is going to be very interesting. So once the agreement goes south and there is someone who defects and this person is detected and caught, then the penalty phase begins. This is the case where we have to deliver our threats. We have the trigger strategy and we said as long as you are good, I am going to be good. Now that I caught you not being good, I have to not be good because if I keep being good then this means that the agreement will not be able to be enforced. So what is going to happen is that everybody will play their Nash strategy, profits will vanish, they will go back to zero. And this will happen for the cheater, so the cheater is punished. But also the non-cheaters, now they will have to suffer in this case because this situation is worse for everybody. So what if the cheater is caught, is punished but comes up with an offer? This offer can be the following. I know that I cheated, but I promise to never do that again. We can take it from the beginning and we would be better off if we pretend that this never happened and we start over again. And this has to be a very sweet offer in order to regain the trust of the other people. Now, what actually happens is that this, in principle, is not a very bad offer because the cheater will lose but also the fair player will lose. And if we are able to get back to the collusion state, they will be both better off. So let's not be selfish, let's forget about what happened in the past, and let's go to enforce a situation which will be better for everybody. So this sounds like a good thing to do. The problem is that if you allow for this kind of renegotiation, collusion cannot be sustained in the first place. Because the only thing that keeps you from cheating is that you know that there will be a case that you are going to get caught. And in this case, you will be asked to pay for that. You will be asked to lose your profits for that. If there is no fear about that and you know that okay, I'll cheat and if I'm caught, I'm going to talk my way out of that. I'm going to convince them that nothing happened and we will get back to the same situation. And who knows, maybe they can tolerate for one more time so I can cheat again. So this is not going to work. There is essentially no penalty phase if we allow for renegotiation. So renegotiation is an issue that has to be solved from the beginning. From the beginning of the game, you have to make it clear to yourself and to everybody else that in case that defection occurs, we mean business. We are going to punish this person even if we like it or if we not like it, we're going to make it as chore to just deal with the cheater. We care for something that is called renegotiation proofness. So this means that when we make an agreement, we have to make this agreement from the beginning. From before someone cheats, we have to make it renegotiation proof, that is, threats for punishment must be credible. In other words, you shouldn't have a dynamic inconsistency where before deflection you say, yes I will punish you if you defect. But after deflection you say, it's all right. I understand you, you just did it once, and then you'll never do it again. This should not happen. If this happens, you lose your credibility and you will be in trouble all the time. So no opportunity for Pareto improvement with renegotiation, meaning that we shouldn't allow for a case after defection that we will revert back to the old solution. And everybody will be better off. We have to fix that from the beginning. Under renegotiation proofness, firms are required to punish the cheaters. And they could actually have incentive to punish than to renegotiate, so they should prefer to punish. Either of this can be achieved with trust, so you betrayed me. We had an agreement, a gentlemans or lay disagreement and you violated that. And now you come to me and you tell me the same story, why should I believe you again? So if you have issues of trust, then renegotiation proofness is guaranteed. You are not going to believe a cheater because he has already cheated on you. But some cases you might not have this situation, so renegotiation proofness has to be made intentionally costly. So we take provisions from the beginning so in case we get to a renegotiation issue, we have to punish you. We make it for ourselves hard to accept your agreement. So we are not going to be tempted afterwards to follow your offer. We make it hard for ourselves from the beginning to not be tempted to follow your offer. So it should be such a situation that if someone cheats, then you prefer to punish than to not. This can be achieved with asymmetry in payoffs. Can you think of an example of such a behavior? The first collusive behavior that we observe and we very often see around us, mostly movies I hope, is collusion that happened between mafia. Mafia organizations, as we see them in the movies, they were nothing more than collusive agreements. They even had someone who would overlook this agreement, the godfather usually. And the godfather, his duty was all the time to enforce and to police agreements. Now, when mafia set the price for something, sometimes there were cheaters and the cheaters would have to be punished. And we all know how mafia treated the cheaters. Now, in some of the movies, you can see the example that someone is setting the price of drugs, let's say, to a smaller amount than it was agreed by the mafia. This would mean that the mafia would lose from the specific spot some $100 per day and then they will get the guy. And the guy will be, don't punish me for a few hundred dollars, I'm going to give them to you back. But we know that even today lots of crimes happen like that, so mafia would not play jokes with this kind of behavior. Did they do it for the $100 or something that they lost that day? No, they were making millions, some of the organizations they even made billions. So why did they have to punish for a few hundred dollars? Just because they want to make clear that if you defect in the agreement, the punishment phase is strict, is absolute, is for everybody. You either follow the agreement or you are not there to see what is going to happen. Stay with us, we are going to have more pleasant examples in the next segments. [MUSIC]
