Prisoner’s Dilemma

Consider this scenario: –

Two Prisoners, A and B, are suspects for a crime and are put behind bars. The cops have no evidences against either of them. So the cops offer the following to each of the prisoners. “If you deny your crime and the other accepts, you get a term of 10 years and the other goes free. If you both accept, each one gets 5 years and if you both deny you both get 6 months each.” The offer is summarized below

	Prisoner B Rejects his crime	Prisoner B Accepts his crime
Prisoner A Rejects his crime	A gets 6 months B gets 6 months	A gets 10 years B goes free
Prisoner A Accepts his crime	A goes free B gets 10 years	A gets 5 years B gets 5 years

Given the above scenario, how do you expect each of the Prisoner’s to react considering the fact that neither of the prisoners knows what the other is going to do.

Consider Prisoner A. What would be the best course of action for Prisoner A given the actions of Prisoner B.

1. If B rejects his crime, the best course of action for A would be to accept his crime.
2. If B accepts his crime, the best course of action for A would be to accept his crime.

Consider Prisoner B. What would be the best course of action for Prisoner B given the actions of Prisoner A.

1. If A rejects his crime, the best course of action for B would be to accept his crime.
2. If A accepts his crime, the best course of action for B would be to accept his crime.

Since neither A nor B are aware of the actions of the other, they both end up accepting their Crimes thereby getting terms of 5 years each.

The above scenario is what is referred to as the Prisoner’s Dilemma and is a classic example of Game Theory. It explains why, even though by co-operating each player can benefit more, each player tries to maximize his/her payoff at the cost of the other player’s payoff.

One application of the above theory is to explain how firms in an Oligopoly work together. Oligopoly refers to a market where there are a few firms competing with each other. If all firms in an oligopoly collude together, they can artificially jack up the prices and earn extra ordinary profits. However, each firm has an incentive to reduce prices in order to increase sales so that they can increase their profits even more as compared to their competitors. Because of this suspicion that the other firms might reduce prices, every firm reduces it prices and the collusion fails. Because of this none of the firms in an Oligopoly earn extraordinary profits.

However, there are Oligopolies that collude and work successfully by raising prices artificially. One example which I can cite is ‘OPEC’.

LiveJournal Tags: Prisoner’s Dilemma,Game Theory,Oligopoly

Commodities

Who invest in Commodities and why?

There are two kinds of investors who invest in commodities. One who use it as a hedging tool to lock future prices and the second who use it to make profits by speculating on the future price movements. The first set of investors are usually investors who want to buy these commodities at a future price but are unsure of the future prices. e.g. Farmers would want to sell their grains at a particular future date. However, they are not sure what the future prices would be. Hence they would go Short in a particular futures contract in order to lock future prices. The same is applicable to any dealer who would be buying Gold on a future date and would want to lock the buying price today.The later set of investors trade on commodity futures and gain/lose depending on the future prices. They trade on these futures not with an intent of getting the actual commodity.

Why do Portfolio Managers like Commodities? 

Commodity futures are the only investment tools providing a negative correlation to all other investment asset classes (stock, bonds, etc). This is because commodities tend to gain (during depressions) when all other asset classes loose value. Due to this -ve correlation commodities help reduce the overall risk of the portfolio hence making it much more attractive to investors.

When to invest in Commodities?

People usually tend to invest in commodities when there are economic downturns. In times of economic depressions, the stock market usually tends to go down. Due to the -ve correlation that commodities have with the stock markets people invest in commodities as a hedging tool.

Technorati Tags: Commodities

Ever heard the terminology top line and bottom line?

Ever heard of the term top line and bottom line being used by financial analysts? So what do these terms refer to and why are they called so.

Starting with top line; it refers to the total sales or revenue generated by a firm.

For e.g. if a firm sells 100 cars/fiscal @ Rs.1,00,000 (oh yes, its the nano!!) then the top line would be Rs.1,00,00,000. (The Math here has been simplified to drive home the point!! ).

Now, say the Net Income (profit) earned on every car is Rs.20,000, then the bottom line would be Rs.20,00,000. (Again, we exclude the effects of Depreciation, Taxes, SG&A and other accounting stuff to keep the math simple).

So why are these terms referred to as they are?

Try reading an income statement of any firm. If you see at the top you would find the Sales/Revenues being shown. Hence, in general usage, Sales/Revenues are referred to as top line because of their close proximity to the top part of an income sheet. If you keep coming down the income statement you will see that there are deductions( depreciation, taxes, interest expenses, etc ) and additions (gain from sale of securities, etc) being made to the top line. After all adjustments are made to the top line, the firm would report its Net Income ( or Profit ) at the bottom of the income statement and hence the term bottom line because of it’s close proximity to the bottom of the income statement.

Also commonly referred as

Top line : – Revenue, Sales

Bottom line: – after tax profit, bottom line, net, net profit, profit

Technorati Tags: Finance,Income Statement