Revisiting the Prisoner's Dilemma

Since our original mention of the Prisoner's Dilemma, we have seen the model pervade the global landscape. In this article, we will revisit the dilemma and discuss how it affects capital markets, our investment process, and the world in general.

What is the Prisoner's Dilemma?

The “Prisoner’s Dilemma” derives its name from an experiment in which police have arrested two suspects and are interrogating them separately. Each can either keep silent or can confess, thereby incriminating the other suspect. The key here is that no matter what the other suspect does, each can improve his own position by confessing, as shown below in Figure 1. If Suspect B confesses, then the Suspect A needs to do the same to avoid the especially harsh sentence for stubbornly holding out. Conversely, if Suspect B keeps silent, then Suspect A will receive favorable treatment by confessing and cooperating with the police. So, no matter what course of action Suspect B chooses, Suspect A maximizes his/her situation. However, ironically, by both confessing, the joint outcome is worse than if both had remained silent.

"Regardless of what the competition does, it is in each producer’s best interest to maintain production. However, by acting in their individual best interests, the producers actually do what is in their joint worst interests."

Figure 1. No Matter the Other Prisoner's Choice, Each Prisoner Improves His/Her Position by Confessing.

Source: Balentine

Prisoner's Dilemma in the Oil Market: A look back at 2014

In our 2016 Capital Markets Forecast, we explained oil prices were not likely to return to the pre-2014 crash levels anytime soon due to the "Prisoner's Dilemma." As seen in Figure 2, after the 2014 oil crash, oil producers continued to pump out more oil in the quest to individually gain market share and save themselves when they should have reduced pumping given the inventory overhang that was capping prices. They did eventually reduce their pumping but only after structural price declines became embedded.

We have proven to be correct about oil prices; even before 2020 crash, oil languished well below the 2014 top and only recently surpassed the top, about 6 years after we published and nearly 7.5 years after the crash.

Figure 2. The Prisoner's Dilemma in the Oil Market Capped the Price during 2014-2021.

Source: FactSet

The Prisoner's Dilemma in Capital Markets

In capital markets, the prisoner’s dilemma is the strategic dynamic that drives the balance between cooperation and competition. Over the long term, the value of a company’s equity tends toward some equilibrium level based mostly on the company’s financials and somewhat on exogenous factors such as interest rate levels. As stock prices are continuously in motion, the values always deviate somewhat from these equilibrium levels; at times, however, the values deviate substantially, as the players in the market get caught in the prisoner’s dilemma dynamic.

Stocks

If a stock price is substantially higher than where fundamentals indicate it should be valued, investors have two options:

1. Hold the stock, which would prevent it from declining in value.
2. Sell the stock, which would allow individual players to realize the inflated value.

If the two investors have all the shares of a particular stock, there are three possible outcomes from the combination of their actions:

1. Person A & Person B Hold. In this scenario, the price of the stock will likely rise as demand to buy will outweigh the supply available for sale. Of course, this does not occur in the market; besides being impractical, investors view the success of others as a potential threat to their own success.
2. Person A Sells & Person B Holds OR Person B Sells & Person A Holds. The seller gets the profit while the holder makes no gains.
3. Person A & Person B Sell. The market loses full value and both players lose money.

It is therefore most beneficial for each person to sell their stock in hopes that the other person will not. However, when each person sells their stock, both end up receiving less than the stock would be valued had they both continued to hold.

Housing Market

The Prisoner’s Dilemma is also present in the housing market. Someone may reasonably assume that in a period of record low interest rates, low wage-to-house price ratios and low wage growth, all of which have served to raise the prices of houses sharply, that the optimal decision for them is to wait a few years for house prices to stabilize a bit. Of course, if everyone else did that, then that’s probably what would occur: interest rates would have room to rise without choking off the economy too much, the decrease in demand would cool off the housing market, and prices would likely slow or even turn into modest decreases.

However, without the ability to coordinate, each prospective homebuyer may assume the need to buy a house before other participants bid up prices further. So, in essence, the “rational” decision to stay out of a frothy market ends up costly. Sure, an economic shock might hit later, but that is external to this decision-making model. Thus, in the end, all prospective homebuyers end up worse off by purchasing a house at underlying prices that are higher than they otherwise would be if the buyers could coordinate.

Balentine's Investment Process

So, how does this prisoner’s dilemma dynamic tie in with the Balentine investment process? Our models are designed to capture long trends in asset cycles. We believe the prisoner’s dilemma is a large factor in the difference between a stock’s intrinsic value (what we call “fundamentals”) and its actual price. The magnitude of this difference determines how much price discrepancies are magnified as they trend up or down. Understanding this dynamic helps us to create a fertile context for our trend-based model process to work. Moreover, our model process allows us to filter out much of the subjective noise that would be grossly impacted by the emotions that come with a prisoner’s dilemma dynamic.

The Prisoner's Dilemma Outside of Capital Markets

Economics

Consider Coke and Pepsi. These soda companies are a duopoly; together, they control their market. Logically, both can make the most money by charging a high price. However, each has a powerful motivation to undercut the other price in the quest to win customers away from its competitor. A low-price strategy is analogous to the prisoner’s confession (i.e., defecting), while a high-price analogous to staying silent (i.e., cooperating). Because defecting is each firm’s dominant strategy, both tend to do so, but the result when both defect is worse for each than that of both cooperating in terms of margins and profits.

Contract Negotiations

Hitting a little closer to home, we are several weeks removed from all-star first baseman Freddie Freeman’s departure from the Atlanta Braves. Everyone assumed that Mr. Freeman and the Braves would reach terms on an extension prior to his contract elapsing. But alas poor Yorick, it did not, with both parties indicating regret. The story is that Mr. Freeman’s agent bungled the situation, but, both parties are responsible for a marriage that was meant to be not coming to pass.

Instead of Freddie Freeman and the Atlanta Braves coming together to figure out the “must haves,” “want to haves,” and “don’t needs,” each party spent last season posturing in the quest to establish a position of strength over the other party. The eventual result led to worse outcomes for both parties:

1. The Braves lose Freddie and give up prospects. The Braves got a first baseman for a lower average annual value than Mr. Freeman was seeking, but they had to trade four blue-chip prospects (including three of their top ten prospects) in order to “break even” for the trade.
2. Freddie leaves the team for which he desired to play. Mr. Freeman ended up: 1) on a team that was not his first choice, 2) for a smaller gross value than he was seeking, and 3) for a smaller net (i.e., post-tax) value than the Braves were offering.

So goes the prisoner’s dilemma when the participants do not cooperate to achieve what is in their joint interest, then both parties end up worse off. Ironically, it can be argued that Mr. Freeman and/or his agent were so stuck to their hard line they lost leverage when the Braves decided to move one, thus leading to a subpar outcome not only in his preferred employer, but also in his compensation when there was less demand for his services than anticipated.

Geopolitics

Hitting on a more serious topic, arms races between nations offer another important example of the prisoner’s dilemma. Both countries are better off when they cooperate and avoid an arms race, yet the dominant strategy for each is to arm itself heavily. We can see this play out today in the Russia – Ukraine Conflict. It seems that Russian President Vladimir Putin’s immediate goal is that Ukraine does not join the North Atlantic Treaty Organization (NATO), which he views as an offensive threat. Ukraine has previously stated a desire to forcibly retake Crimea, so it’s logical that Putin would view Ukraine’s pursuit of NATO membership as a vehicle achieving that. In pondering how to resolve this conflict, it’s not far-fetched to suggest Putin would respect the territorial integrity of Ukraine for the assurance that Ukraine would not join NATO.

The prisoner’s dilemma is evident in considering potential courses of action for Russia and the West, to whom many look to resolve the situation. The West is not willing to negotiate with Russia or grant any concessions. Now, Russia is less likely to negotiate in good faith because it views the West as an aggressor and itself as doing what is necessary to for defense. Additionally, the West believes that sanctions are a way to deter Russia from its aggression, but sanctions are more likely to poke the bear than de-escalate the situation because it justifies Putin’s view that the West is bullying Russia.¹

There are three ways this situation will be resolved:

1. Submission. This will not happen with either side.
2. Compromise. This is becoming increasingly unlikely as the prisoner’s dilemma takes hold, leading each party to act in its own interests in the quest to optimize its individual outcome.
3. War. This is where conflict stands today.

Does war mean all hope is lost? Not yet, but both parties must understand the lesson of the prisoner’s dynamic: they could both be better off via coopetition² vs. pure competition.

Imagine a scenario in which NATO precluded Ukraine’s membership, essentially making it de facto neutral ground between Russia and the West. This could be enough to satisfy Putin. Right now, the West does not believe there is any justification to compromising with Russia. However, in the scenario above, the West would have to get past this to achieve peace. Resolving a prisoner’s dilemma is about getting to a superior joint outcome, not about getting everything desired.

Resolving the Dynamic

How do “prisoners” extricate themselves from the dilemma and sustain cooperation when each has a powerful incentive to defect? The most common path to cooperation arises from repetitions of the dynamic. In the Coke-Pepsi example, each company will, at times, benefit in the short term from its own defection while at other times will suffer in the short term from the opponent’s defections. Thus, the result may be no net gain is accrued from defecting, which may serve as a deterrent for both parties.

Of course, while this works in an ongoing dynamic such as the Coke-Pepsi example, it would not be relevant to a one-time dynamic such as a baseball contract negotiation. In one-time examples, there is often little incentive not to defect, which helps explain why the dynamic is so pervasive. Once acutely aware of how pervasive the dynamic is, people may find themselves in the dynamic more often than had previously thought, which may now make for an altered way of approaching the dynamic both inside and outside the capital markets.

Conclusion

The Prisoner’s Dilemma describes a paradox in which two actors deploy logic to maximize their personal benefit with no consideration of the effect on the other. In doing so, they create a combined outcome that is worse for both. Understanding this dilemma provides deeper insight into the world around us; It can be used to explain some of the methodology behind much of what goes on in the world, including but not limited to Balentine’s investment process. Now that you have learned about the Prisoner’s Dilemma, we invite you to consider where you have experienced it before and how it may impact decisions in which you face such a dilemma. As always, if you have any questions, please reach out to a Relationship Manager.

¹As an aside, we are not blessing Putin’s view, rather we are speculating on what it may be, irrespective of what would be morally the correct approach.

²A portmanteau of cooperation and competition, when competitors cooperate to a limited degree to with the goal of optimal joint success. In capitalist competition, there can be legal limits to this (e.g., the illegality of price fixing).