The Economy as a Prisoner’s Dilemma

The current economic crisis can be modeled as an iterated (multi round) prisoner’s dilemma between firms and consumers:

 

 

Business

 

 

Keep Workers

Layoff Workers

Consumers

Buy

7,7

1,10

Don’t  Buy

10,1

3,3

 

In the chart above, 1 is the worst outcome and 10 is the best outcome. The best mutual outcome is for consumers to keep buying merchandise and for firms not to layoff workers (this is economic growth). However, individually, if consumers think they may get laid off, not get bonuses, or not get a salary raise, they will stop buying things. This will be better for them in the short run as the worst outcome is for them to keep buying things and then get laid off, but the same “saving money” behavior will hurt them in the next round of this model, when firms lay off workers. The reverse is true as well, where a firm would benefit by “trimming the fat” even if its competitors keep their workers for the first round, but if all firms lay people off, consumers will stop spending (they won’t have jobs) and more layoffs will be necessary as purchasing power drops.

Financial Mania

“I knew it was time to sell my stock when the taxi driver was giving me investment advice.” Said one of the robber barons during the great depression. (A google search failed to give me a more specific citation.)

I came across this article today while reading about Rutgers Football:

“I’m broke,” he shrugged, while munching on a tuna sub earlier this week in the Hale Center. “I realized this could be a way I could make some money.”

“I roomed with him and he was watching all that stuff,” Silvestro said. “I’m in an accounting class, so I guess I should be paying attention. All the time he tells me what he’s going to do (investment-wise). I listen and it sounds good what he’s saying. I think he knows what he’s doing.”

When he’s not digesting Rutgers’ defensive playbook, Tverdov is searching for investment tips on the internet.

“I read some articles on CNN Money, MSN Money, and then I’ll buy a book here and there when I have time,” Tverdov said. “It’s something I’d like to do when I graduate.”

Problem is, Tverdov majored in criminal justice.

“Coach Schiano told me I could guard money, that’s about it,” Tverdov quipped.

I love the football team and am not trying to make fun of them. I’m glad they have other interests and are eager learners. This is just more of an example of  when anyone and everyone starts to think they can get rich off the market, that’s when a you have the makings of a bubble.

If you’re interested in why this is happening (and why it’ll happen again) you must read The Black Swan by Nassim Taleb.