Tag: Prisoners Dilemma

What Competition in Nature Should Teach Us about Markets

“Though the free-market faithful have long preached that competition creates efficiency, as if it were a law of nature, nature itself teaches a different lesson.”

No tree can afford to not compete in the height competition. However, if somehow the trees could arrange a pact of friendship to limit their heights, each tree, and the forest as a whole, could save energy. This is obviously not possible for trees, but if it were, Dawkins concludes, the “Forest of Friendship [would be] more efficient as a forest.”

Systems of self-interested agents, responding only to local incentives, can easily evolve energy-wasting, unfruitful competitions. Dawkins doesn’t make the obvious connection between free- market theory and freely evolved systems, but you should. Once a way of competing is established, it’s very difficult for individuals not to play along. If we let our economies imitate trees, and the majority of nature, in practicing unguided free competition, the results will often be suboptimal, for each and for all. Worse, we will miss the main benefit of being human, which is to use reason to coordinate better outcomes.

The way wasteful competition gets entrenched is a worrying example of an entire class of errors in which what passes for rational decisions can create undesirable outcomes. These include the tragedy of the commons, Prisoner’s Dilemma-type games, and Nash equilibria. Applying a narrowly self-maximizing logic yields suboptimal results for everybody.

Still curious? Try reading The Darwin Economy.

Mental Model: Prisoners’ Dilemma

The prisoners’ dilemma is the best known strategy game in social science. The game shows why two entities might not cooperate even when it appears in their best (rational) interest to do so. What is rational for the individual in certain circumstances is not rational for the group — that is, pursuing a strategy that is rational for you leads to a worse outcome.

With applications to economics, politics, and business the game illustrates the conflict, which can sometimes arise, between individual and group rationality.

From Greg Mankiw’s Economics textbook:

The prisoners’ dilemma is a story about two criminals who have been captured by the police. Let’s call them Mr Black and Mr Pink. The police have enough evidence to convict Mr Black and Mr Pink of a relatively minor crime, illegal possession of a handgun, so that each would spend a year in jail. The police also suspect that the two criminals have committed a jewelery robbery together, but they lack hard evidence to convict them of this major crime. The police question Mr Black and Mr Pink in separate rooms, and they offer each of them the following deal:

Right now we can lock you up for 1 year. If you confess to the jewelery robbery and implicate your partner, however, we’ll give you immunity and you can go free. Your partner will get 20 years in jail. But if you both confess to the crime, we won’t need your testimony and we can avoid the cost of a trial, so you will each get an intermediate sentence of 8 years.

If Mr Black and Mr Pink, heartless criminals that they are, care only about their own sentences, what would you expect them to do? Would they confess or remain silent? Each prisoner has two strategies: confess or remain silent. The sentence each prisoner gets depends on the strategy chosen by his or her partner in crime.

Consider first Mr Black’s decision. He reasons as follows:

I don’t know what Mr Pink is going to do. If he remains silent, my best strategy is to confess, since then I’ll go free rather than spending a year in jail. If he confesses, my best strategy is still to confess, since then I’ll spend 8 years in jail rather than 20. So, regardless of what Mr Pink does, I am better off confessing.

In the language of game theory, a strategy is called a dominant strategy if it is the best strategy for a player to follow regardless of the strategies pursued by other players. In this case, confessing is a dominant strategy for Mr Black. He spends less time in jail if he confesses, regardless of whether Mr Pink confesses or remains silent.

Now consider Mr Pink’s decision. He faces exactly the same choices as Mr Black, and he reasons in much the same way. Regardless of what Mr Black does, Mr Pink can reduce his time in jail by confessing. In other words, confessing is a dominant strategy for Mr Pink.

In the end, both Mr Black and Mr Pink confess, and both spend 8 years in jail. Yet, from their standpoint, this is a terrible outcome. If they had both remained silent, both of them would have been better off, spending only 1 year in jail on the gun charge. By each pursuing his own interests, the two prisoners together reach an outcome that is worse for each of them.

To see how difficult it is to maintain cooperation, imagine that, before the police captured Mr Black and Mr Pink, the two criminals had made a pack not to confess. Clearly, this agreement would make them both better off if they both live up to it, because they would each spend only 1 year in jail. But would the two criminals in fact remain silent, simply because they had agreed to? Once they are being questioned separately, the logic of self-interest takes over and leads them to confess. Cooperation between the two prisoners is difficult to maintain because cooperation is individually irrational.

* * *

Michael J. Mauboussin writes:

The classic two-player example of game theory is the prisoners’ dilemma. We can recast the prisoners’ dilemma in a business context by considering a simple case of capacity addition. Say two competitors, A and B, are considering adding capacity. If competitor A adds capacity and B doesn’t, A gets an outsized payoff. Likewise, if B adds capacity and A doesn’t than B gets the large payoff. If neither expands, A and B aren’t as well-off as if one alone had added capacity. But if both add capacity, they’re worse off of than if they had done nothing.

* * *

Avinash Dixit offers:

Consider two firms, say Coca-Cola and Pepsi, selling similar products. Each must decide on a pricing strategy. They best exploit their joint market power when both charge a high price; each makes a profit of ten million dollars per month. If one sets a competitive low price, it wins a lot of customers away from the rival. Suppose its profit rises to twelve million dollars, and that of the rival falls to seven million. If both set low prices, the profit of each is nine million dollars. Here, the low-price strategy is akin to the prisoner’s confession, and the high-price akin to keeping silent. Call the former cheating, and the latter cooperation. Then cheating is each firm’s dominant strategy, but the result when both “cheat” is worse for each than that of both cooperating.

* * *

Warren Buffett provides some illumination as to how the Prisoners’ Dilemma plays out in business in the 1985 Berkshire Hathaway Annual report.

The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage. But that in no way means that our labor force deserves any blame for our closing. In fact, in comparison with employees of American industry generally, our workers were poorly paid, as has been the case throughout the textile business. In contract negotiations, union leaders and members were sensitive to our disadvantageous cost position and did not push for unrealistic wage increases or unproductive work practices. To the contrary, they tried just as hard as we did to keep us competitive. Even during our liquidation period they performed superbly. (Ironically, we would have been better off financially if our union had behaved unreasonably some years ago; we then would have recognized the impossible future that we faced, promptly closed down, and avoided significant future losses.)

Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industry-wide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers. I always thought myself in the position described by Woody Allen in one of his movies: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray we have the wisdom to choose correctly.”

For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.

Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington’s basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational.

Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 — on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.

This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise. The situation is suggestive of Samuel Johnson’s horse: “A horse that can count to ten is a remarkable horse – not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.

My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Some years ago I wrote: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.

* * *

Mauboussin adds:

Our discussion so far has focused on competition. But thoughtful strategic analysis also recognizes the role of co-evolution, or cooperation, in business. Not all business relationships are conflictual. Sometimes companies outside the purview of a firm’s competitive set can heavily influence its value creation prospects.

Consider the example of DVD makers (software) and DVD player makers (hardware). These companies do not compete with one another. But the more DVD titles that are available, the more attractive it will be for a consumer to buy a DVD player and vice versa. Another example is the Wintel standard—added features on Microsoft’s operating system required more powerful Intel microprocessors, and more powerful microprocessors could support updated operating systems. Complementors make the added value pie bigger. Competitors fight over a fixed pie.

* * *

Mankiw offers another real world example:

Consider an oligopoly with two members, called Iran and Saudi Arabia. Both countries sell crude oil. After prolonged negotiation, the countries agree to keep oil production low in order to keep the world price of oil high. After they agree on production levels, each country must decide whether to cooperate and live up to this agreement or to ignore it and produce at a higher level. The following image shows how the profits of the two countries depend on the strategies they choose.

Suppose you are the leader of Saudi Arabia. You might reason as follows:
I could keep production low as we agreed, or I could raise my production and sell more oil on world markets. If Iran lives up to the agreement and keeps its production low, then my country ears profit of $60 billion with high production and $50 billion with low production. In this case, Saudi Arabia is better off with high production. If Iran fails to live up to the agreement and produces at a high level, then my country earns $40 billion with high production and $30 billion with low production. Once again, Saudia Arabia is better off with high production. So, regardless of what Iran chooses to do, my country is better off reneging on our agreement and producing at a high level.

Producing at a high level is a dominant strategy for Saudi Arabia. Of course, Iran reasons in exactly the same way, and so both countries produce at a high level. The result is the inferior outcome (from both Iran and Saudi Arabia’s standpoint) with low profits in each country.

This example illustrates why oligopolies have trouble maintaining monopoly profits. The monopoly outcome is jointly rational for the oligopoly, but each oligopolist has an incentive to cheat. Just as self-interest drives the prisoners in the prisoners’ dilemma to confess, self-interest makes it difficult for the oligopoly to maintain the cooperative outcome with low production, high prices and monopoly prices.

Other examples of prisoners’ dilemma’s include: arms races, advertising, and common resources (see the Tradegy of the Commons)

The Prisoners’ Dilemma is part of the Farnam Street latticework of Mental Models.

Thinking about Thinking

the thinker

While Daniel Kahneman’s book, Thinking Fast, Thinking Slow, gets all the attention, he’s also written a few articles that might catch your interest.

Optimistic Bias:

In terms of its consequences for decisions, the optimistic bias may well be the most significant cognitive bias. Because optimistic bias is both a blessing and a risk, you should be both happy and wary if you are temperamentally optimistic.

Competition Neglect

Colin Camerer, who coined the concept of competition neglect, illustrated it with a quote from a chairman of Disney Studios. Asked why so many big-budget movies are released on the same holidays, he said, “Hubris. Hubris. If you only think about your own business, you think, ‘I’ve got a good story department, I’ve got a good marketing department’ … and you don’t think that everybody else is thinking the same way.” The competition isn’t part of the decision. In other words, a difficult question has been replaced by an easier one.

This is a kind of dodge we all make, without even noticing. We use fast, intuitive thinking — System 1 thinking — whenever possible, and switch over to more deliberate and effortful System 2 thinking only when we truly recognize that the problem at hand isn’t an easy one.

The question that studio executives needed to answer is this: Considering what others will do, how many people will see our film? The question they did consider is simpler and refers to knowledge that is most easily available to them: Do we have a good film and a good organization to market it?

Appreciation of uncertainty

As Nassim Taleb, the author of “The Black Swan,” has argued, inadequate appreciation of the uncertainty of the environment inevitably leads economic agents to take risks they should avoid. However, optimism is highly valued; people and companies reward the providers of misleading information more than they reward truth tellers. An unbiased appreciation of uncertainty is a cornerstone of rationality — but it isn’t what organizations want. Extreme uncertainty is paralyzing under dangerous circumstances, and the admission that one is merely guessing is especially unacceptable when the stakes are high. Acting on pretended knowledge is often the preferred approach.

Theory-induced blindness

Bernoulli invented psychophysics to explain this aversion to risk. His idea was straightforward: People’s choices are based not on dollar values but on the psychological values of outcomes, their utilities. The psychological value of a gamble is therefore not the weighted average of its possible dollar outcomes; it is the average of the utilities of these outcomes, each weighted by its probability.

…That Bernoulli’s theory prevailed for so long is even more remarkable when you see that, in fact, it is seriously flawed. The errors are found not in what it asserts explicitly, but what it tacitly assumes.

The mystery is how a conception that is vulnerable to such obvious counterexamples survived for so long. I can explain it only by a weakness of the scholarly mind that I have often observed in myself. I call it theory-induced blindness: Once you have accepted a theory, it is extraordinarily difficult to notice its flaws. As the psychologist Daniel Gilbert has observed, disbelieving is hard work.

Reference points and loss aversion

The economists Devin Pope and Maurice Schweitzer, at the University of Pennsylvania, suggest that golf provides the perfect example of a reference point: par. For a professional golfer, a birdie (one stroke under par) is a gain, and a bogey (one stroke over par) is a loss. Failing to make par is a loss, but missing a birdie putt is a forgone gain, not a loss. Pope and Schweitzer analyzed more than 2.5 million putts to test their prediction that players would try harder when putting for par than when putting for a birdie.

They were right. Whether the putt was easy or hard, at every distance from the hole, players were more successful when putting for par than for a birdie.

…If you are set to look for it, the asymmetric intensity of the motives to avoid losses and to achieve gains shows up almost everywhere. It is an ever-present feature of negotiations, especially of renegotiations of an existing contract, the typical situation in labor negotiations, and in international discussions of trade or arms limitations. Loss aversion creates an asymmetry that makes agreements difficult to reach.

Negotiations over a shrinking pie are especially difficult because they require an allocation of losses. People tend to be much more easygoing when they bargain over an expanding pie.

In the world of territorial animals, the principle of loss aversion explains the success of defenders. A biologist observed that “when a territory holder is challenged by a rival, the owner almost always wins the contest — usually within a matter of seconds.”

Youngme Moon: On Business Competition and Escaping the Competitive Herd

There are many ways companies compete with one another. Unfortunately, a lot of those ways seem like nothing more than an expensive route to commoditization.

Companies are relentless in their pursuit of finding their weaknesses. They hire consultants, create branding maps, and solicit customer feedback. In our hyper-competitive world, this feedback tells us what we’re missing—our weaknesses.

Companies, like people, fall into the habit of thinking the way to be better is to become more like everyone else.

  • Jane’s company just introduced a new line of green worms? We need green worms too preferably caffeine enhanced green worms.
  • Bob decided to offer a new service? We need a new service too!
  • When you ask your customers what they want they respond with what you’re missing.
  • When consultants compare your products to others they tell you what the competition offers that you don’t.

“A funny thing happens when you begin to capture competitive differences on paper”, says Harvard Professor Youngme Moon in her book Different: Escaping the Competitive Herd, “there is a natural inclination for folks in the competitive set to focus on eliminating differences rather than accentuating them.”

Eliminating Differences

Our brains have been wired since birth to eliminate our differences.

We’ve all received school report cards. If you’re like most people, at some point or another, you discovered you were below the class average in something. We all knew our parents would pick up on that weakness right away.

I cringed before coming home if I was even a hair below average in anything. After a mother saw that report card, it didn’t matter how awesome you were in physics and math. The only thing that mattered was the fact that you were below average in art.

If your mother was like my mother, you wouldn’t hear the end of it until you were once again average in art.

As adults, the only thing that has changed is who gives the report card.

Managers across the country hand out performance reviews that highlight your strengths and weaknesses. Of course, your boss wants you to address those weaknesses. He wants you to be more like everyone else. And since keeping your job is a pretty big incentive, you eagerly put your head down and do what you’ve done your whole life: rather than accentuate the differences you address your weaknesses and, in the process, become more average and indistinguishable from everyone else.

In the process, you move increasingly towards becoming a commodity.

Competition

It’s like we’re back in school all over; competitors and customers are telling us what we don’t have—where we’re below average. Only now this isn’t grade school. The stakes are higher. It’s winner take all and our competitive spirits take over. Except, increasingly, there is no winner.

Consumers can’t tell company Y from Company X. Shelves in grocery stores are full of products that are all essentially the same. Companies think that the way to improve their laundry detergent is simply to add a new, previously unknown, fragrance. Being more of the same is, according to Moon, making brand loyalty harder to find.

Of course, if consumers pay close attention, these products have minute differences. But most of these differences are essentially meaningless.

Competing by eliminating our differences seems like nothing more than an expensive route to commoditization.

  • When one airline introduced frequent flier miles the rest soon followed and the industry offerings were, once again, almost indistinguishable.
  • When the Westin started offering the Heavenly Bed as a way to differentiate itself from the competition, almost immediately most other hotels at the same price point upgraded their mattresses too. The only problem was that room rates didn’t increase to make up for the new investment. When everyone can offer essentially the same bed it becomes hard to differentiate yourself and raise prices in the process.

Ultimately, all of the advantages flow to the customers (and the mattress companies).

According to Moon, “The more generous the baseline value proposition becomes within the category, the easier it becomes for consumers to become indifferent and the more expensive it becomes for businesses to compete.” Investing in differentiation without the ability to increase prices or market share only reduces returns.

In the race to become more like everyone else, companies often don’t think through the whole problem.

They “don’t do the second step of the analysis which is to determine how much is going stay home and how much is just going to flow through to the customer,” says longtime investor Charlie Munger.

I’ve never seen a single projection incorporating that second step in my life. And I see them all the time. Rather, they always read: This capital outlay will save you so much money that it will pay for itself in three years. So you keep buying things that will pay for themselves in three years. And after 20 years of doing it, somehow you’ve earned a return of only about 4% per annum.

If this sounds vaguely familiar it should. It’s a variation of the prisoners’ dilemma; the best choice for all companies is not the best choice for each individual company.

I’m not saying that all competition based on product augmentation (either through new sub-categories or new features) is a flawed strategy. Under the right circumstances, some of these investments can, and will, pan out. I am saying that if your business is pursuing one of these strategies as a means of differentiating yourself from competition, you need to critically think through this strategy.

Read more in Youngme Moon’s Book—Different: Escaping the Competitive Herd

Social Dilemmas: When to Defect and When to Cooperate

Social dilemmas arise when an individual receives a higher payoff for defecting than cooperating when everyone else cooperates. When everyone defects they are worse off. That is, each member has a clear and unambiguous incentive to make a choice, which if made by all members provides a worse outcome.

A great example of a social dilemma is to imagine yourself out with a group of your friends for dinner. Before the meal, you all agree to share the cost equally. Looking at the menu you see a lot of items that appeal to you but are outside of your budget.

Pondering on this, you realize that you’re only on the hook for 1/(number of friends at the dinner) of the bill. Now you can enjoy yourself without having to pay the full cost.

But what if everyone at the table realized the same thing? My guess is you’d all be stunned by the bill, even the tragedy of the commons.

This is a very simple example but you can map this to the business word by thinking about healthcare and insurance.

If that sounds a lot like game theory, you’re on the right track.

I came across an excellent paper[1] by Robyn Dawes and David Messick, which takes a closer look at social dilemmas.

A Psychological Analysis of Social Dilemmas

In the case of the public good, one strategy that has been employed is to create a moral sense of duty to support it—for instance, the public television station that one watches. The attempt is to reframe the decision as doing one’s duty rather than making a difference—again, in the wellbeing of the station watched. The injection of a moral element changes the calculation from “Will I make a difference” to “I must pay for the benefit I get.”

The final illustration, the shared meal and its more serious counterparts, requires yet another approach. Here there is no hierarchy, as in the organizational example, that can be relied upon to solve the problem. With the shared meal, all the diners need to be aware of the temptation that they have and there need to be mutually agreed-upon limits to constrain the diners. Alternatively, the rule needs to be changed so that everyone pays for what they ordered. The latter arrangement creates responsibility in that all know that they will pay for what they order. Such voluntary arrangements may be difficult to arrange in some cases. With the medical insurance, the insurance company may recognize the risk and insist on a principle of co-payments for medical services. This is a step in the direction of paying for one’s own meal, but it allows part of the “meal’ ‘ to be shared and part of it to be paid for by the one who ordered it.

The fishing version is more difficult. To make those harvesting the fish pay for some of the costs of the catch would require some sort of taxation to deter the unbridled exploitation of the fishery. Taxation, however, leads to tax avoidance or evasion. But those who harvest the fish would have no incentive to report their catches accurately or at all, especially if they were particularly successful, which simultaneously means particularly successfully—compared to others at least—in contributing to the problem of a subsequently reduced yield. Voluntary self-restraint would be punished as those with less of that personal quality would thrive while those with more would suffer. Conscience, as Hardin (1968) noted, would be self-eliminating. …

Relatively minor changes in the social environment can induce major changes in decision making because these minor changes can change the perceived appropriateness of a situation. One variable that has been shown to make such a difference is whether the decision maker sees herself as an individual or as a part of a group.

Footnotes
  • 1

    Dawes RM, Messick M (2000) Social Dilemmas. Int J Psychol 35(2):111–116