longhedge Geopolitics

Trade War as Prisoner’s Dilemma

A trade war is like a Prisoner’s Dilemma game gone wrong.

  • (1) Trust between both sides has eroded.
  • (2) They cannot communicate effectively.
  • (3) They decide to forego cooperation and defect.
  • (4) And, by foregoing cooperation both sides are hurt.

In a prisoner’s dilemma game, two players are separated (can’t communicate) and given two choices: cooperate or defect. The only winning outcome is when both players choose to cooperate. 

There is a special kind of prisoner’s dilemma game, where the game is repeated many times over and the players can remember the other player’s actions. This means past rounds matter, reputation matters. In these prisoner’s dilemma games, a winning strategy emerges: Tit-for-Tat.

How Tit-for-Tat wins Prisoner’s Dilemma games

First off, the Tit-for-Tat strategies that win are slightly modified. They have a function that tries to break a negative ‘defection’ cycle by forgiving the other party and making the first move to cooperate. 

Forget injuries, never forget kindness

More specifically the winning strategies tend to be: “nice (never the first to defect), retaliating (willing to defect), forgiving (willing to attempt to regain trust by breaking a defection cycle), and non-envious (not specifically attempt to outscore individual opponents)”[1]. I’m going to focus on forgiving because that is where the cycle gets broken.

In a standard Tit-for-Tat strategy you copy the move of your opponent. If they defect : you defect, if they cooperate : you cooperate. This easily turns into a negative cycle, where both sides keep defecting (and spending a lot of extra time in jail).

The negative cycle is broken first by forgiveness and second by extending a hand (attempting cooperation). One side decides to forgive and tries cooperation for two rounds.

Why two rounds? Because the players don’t know the other player’s action until after the round. The first round forgiveness is the signal. The second round is the real chance for cooperation:

  • If the other side cooperates, the negative cycle is broken. (Hurrah!)
  • If the other side refuses cooperation, in the next round (the third) the forgiving player switches back to escalation. The negative cycle continues.

Here’s some food for thought on forgiveness:

  • “记人之善，忘人之过” – 三国志 forget injuries, never forget kindness.
  • “We must develop and maintain the capacity to forgive. He who is devoid of the power to forgive is devoid of the power to love. There is some good in the worst of us and some evil in the best of us. When we discover this, we are less prone to hate our enemies.” – Martin Luther King, Jr.
  • “To forgive is to set a prisoner free and discover that the prisoner was you.” – Lewis B. Smedes

Forgiveness is the intentional and voluntary process by which a victim undergoes a change in feelings and attitude regarding an offense, lets go of negative emotions such as vengefulness, forswears recompense from or punishment of the offender, however legally or morally justified it might be, and with an increased ability to wish the offender well.

Wikipedia [2]

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longhedge Investing

Assets: Atoms versus Electrons

In this post I focus on the assets of a business, stuff that is owned by the business and is fundamental to the business model. Human capital is fundamental as well, but I will leave that for another day.

Note: the impetus of this post was a conversation with Elliott and Michael on China Tech Investor podcast (23): Is Luckin Coffee a real business? I believe Luckin Coffee is using scaling techniques that work for electron businesses but are not suited for atom businesses.

A post on Luckin Coffee where I will share my analysis on their traffic is in the works, you can follow this blog to receive posts by email. — And on to the post.

There is a difference between atom businesses (primarily focused on physical) and electron businesses (primarily focused on digital). Hat tip to Josh Wolfe for this concept.

Electron businesses are primarily media and software (in some cases intellectual property). They are supported by highly efficient infrastructure: fiber optic and copper data transfer, electricity generation and distribution, and electronic devices. Media and software is codified and stored on physical devices (sometimes in electrons), and can be infinitely flawlessly replicated. Storage costs for media and software are near zero: a hard drive on a laptop. Operating cost for software is low and can be “on demand”. Media operating cost is more about keeping it organized and available. Media and software have production cost and distribution cost. After media is produced it is in storage awaiting distribution. Maintenance costs for media are near zero. For software there are maintenance costs, they can range from high to low depending on complexity of the software and the rate of change in the underlying physical layer.

Atom businesses are primarily composed of physical things: assets or —stuff. All assets degrade over time to the point they are useless. Proper care and maintenance can extend an asset’s life, but it’s not free. Physical businesses also require “space” in the form of land or a physical location, which have to be found and acquired and come with carrying costs (such as leases, taxes). Physical locations (land, stores) are not easily spun-up or spun-down, unless a contractual-layer in the middle makes it so (such as a business renting month-to-month from WeWork).

Contractual-layer businesses redefine the contractual relationship on either the supply-side or the demand-side, usually the supply-side. For example, Uber redefined the supply-side for hired drivers (taxis, private car services) by allowing anyone with a phone and a car to become a driver, in effect circumventing the hiring/vetting process or stringent cab-driver license requirements. This lowered the barrier for drivers on the supply side. On the demand side, Uber used infrastructure available (electronic devices and GPS) to replace location-based hailing (standing on the sidewalk) and phone-call hailing with an app on a device with GPS.

Thanks for reading. I welcome your thoughts and comments. Tell me how I’m wrong on Twitter @jameshullx or on LinkedIn.