Wednesday, November 12, 2008

Game Theory - Part 1

Game theory is something that was very popular about 10 years ago I think. It tries to mathematically deduce what is the best course of action given a set of circumstances. The most simplistic example would be the famous Prisoner Dilemma.

For the uninitiated, I will give a Singapore version. Say two opposition party members ganna sued by our beloved Gahmen and are put into difficult situations. The Gahmen needs either one of them to confess in order to sue them till their pants drop, so has resorted to interrogate each of them separately whether they want to confess to their crimes.

Gahmen: Hey loser, if you confess your crime and sabo your friend, we will lighten the sentence for you.

Opposition: I will never befray my comrade, screw you!

Gahmen: You sure? Your friend in the next room is going sabo you, you know?

Opposition: You are lying! He will never betray me, we play Goli together one!

Gahmen: Look we are the most transparent, most efficient, most clean Gahmen in the world basically here are your choices:

1) If you don't confess, and he sabos you, you get sued $1mn, he just pays $1000 for wasting our time and walk away
2) You confess and sabo him, you pay $1000 and walk away
3) If you both sabo each other, you get sued $1mn each
4) If you both don't confess, basically we lock you two up for 3 days, you both pay nothing and then you can walk, bcos we have no other way to get evidence

Transparent enough right? So it depends whether you trust your friend or not, if you really think he will not sabo you, then you should not confess.

Opposition: He will never betray me, we play Goli together one!

Ok, so that's Prisoner Dilemma. How does it apply to investing?

Essentially, a firm in a competitive industry is always in the prisoner's situation.
1) If the firm cut prices and competition doesn't, then it gains market share
2) If competition cut prices and the firm doesn't then it loses market share
3) If both cut prices, then both are in a worse situation than before
4) If both maintain prices, or even better, both raise prices then both parties will improve their situations

Well, value investors look for firms that won't get into this kind of situation. Firms in businesses where there is no competition or somehow the firm has a huge economic moat that shields it from price wars or other threats.

In the next post, we shall discuss a real life competitive industry involving Prisoner's Dilemma

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