Game theory is the strategic analysis of competitive scenarios where decisions made will be dependent on other participants choices. Read up on a brief but clear description of Game Theory HERE. Here’s a story;
Paul and James are two criminals that just robbed a casino. They were successful in their heist and got away. There’s some speculation that links the robbery to their identity, but there’s no solid evidence that suggests it. The federal police launches an investigation regardless, because fortunately they have leverage; a tab of Paul & James’ criminal history of unrelated criminal activities that they can do time for.
The only way for the police to successfully convict the two criminals for the robbery is to get one to turn on the other in exchange for no punishment. So the cops will be using threats, blackmail & anything else they can, so one of them cracks under pressure and snitches on the other. The two criminals are good friends and have promised to never snitch on each other no matter what happens. And the cops are about to test the credibility of that promise.
Standard procedures take place; the police question both criminals separately cutting all communications between them.
Probability or Strategy?
Here is how game theory suggests the scenario plays out:
There’s 4 possibilities that will yield different results. In the first case, neither men talk and both get one year in prison.
2nd case: If either men snitch on one while the other remains silent; one man goes free while the other is sentenced to 8 years.
If both men snitch on each other, both get 4 years. The duration would be less so it can incentivize confession. Because they have both confessed rather than remain silent, they get a shorter sentencing.
No matter how you look at the scenario, its in both men’s best interest to snitch on their partner. Because the prospect of doing no time is far too tempting to not consider snitching. And who is to say James wont snitch on Paul anyway? Or is Paul trustworthy enough as a friend to choose to do one year and not spill?
The correct choice is to snitch. Staying silent is the wrong move. Confessing will either free you from sentencing or AT LEAST reduce your sentencing down to 4 years. Game theory suggests that cheating is the logical self-preserving choice.
Obviously the best case scenario for both men is to remain silent, so they both get one year each. But the logic of the most dominant strategy is so compelling, that confession becomes the choice to make.
How does this relate to business?
Imagine you’re in a sector that provides goods and services with several other competitors doing the same. Take OPEC for example. OPEC is a organisation that includes several countries that are key oil-exporting nations. All the nations in OPEC practically control the worlds oil reserves. The way the organisation works is simple; they product oil, sell it to oil companies (like ExxonMobil, Shell, BP) who in turn sell it to consumers.
These handful of countries have the opportunity to collude so they can create a monopoly and profit massively. Because they essentially have no competitors.
But here’s the problem:
If OPEC collectively decide to produce 30 million barrels a day at a agreed rate of $80 per barrel, then monopoly would work. Each country will produce accordingly to make up the quota and profit accordingly at the agreed price. If Country A sticks to the quota agreement, it assumes the other countries would also uphold it. Cheating silently by overproducing several million barrels, would have Country A profit tremendously at the fixed price of $80 per barrel. And if Country B decides to cheat by overproducing, then this is just another incentive for Country A to cheat and cash in on the extra barrels.
So what happens?
Every OPEC country starts overproducing, increasing the supply and driving down the prices. They fail to act in a monopoly because its in every country’s best interest to overproduce and make more money, until the supply reaches such abundance that the price drops considerably. The only country that could still make money under dirt cheap prices is the country who can produce oil the most cost-efficient way.
Saudi Arabia has so much oil reserves (and can produce oil considerably cheaper than any other country) that it simply threatens the cheating-nations by dumping its reserves on to the market, driving down the price of oil so low that it forces every OPEC nation to renegotiate the agreement and stick to the quota. But this remains to be ineffective, because Saudi Arabia’s capacity to saturate the market with oil doesn’t affect the price low enough to pressure other nations to behave. And so we are left with OPEC never operating properly.
It was Adam Smith who put it forward that “The invisible hand describes the unintended social benefits of an individual’s self-interested actions”. Despite cartels and oligopolies having the advantage to jack up the prices as if they have a monopoly, conditions lead for companies to act on their own accord to maximize their own profits but inadvertently lead to societal benefits. Every time an OPEC nation decides to cheat by overproducing, it creates a domino effect where all the other members follow suit until oil prices drop, in which society subsequently benefits.
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