Game theory is a topic of study in economics that focuses on the behavior of individuals (or organizations) in strategic situations wherein the success of one individual is contingent on the actions taken by another individual. In its purist form, game theory is based on mathematics. Game theory was pioneered by John von Neumann and Oskar Morgenstern in their 1944 book Theory of Games and Economic Behavior. Since then, eight people have won the Nobel prize in economics for their research in game theory.

One of the concepts from game theory is the prisoner’s dilemma. Typically, it is illustrated in a vignette similar to what follows and from which its name derives: Two men who have been charged by a prosecutor with being partners in a crime. The men are in separate jail cells and cannot communicate with one another. The prosecutor does not have sufficient evidence to convict them on the most serious charges against them and therefore needs one alleged criminal to testify against the other. The prosecutor offers each prisoner the same deal: if the prisoner testifies against his partner, he will go free and his partner will do about eight years behind bars. However, if both prisoners refuse to testify and remain silent, both of them will get a light sentence of six months in jail for a lesser crime. Finally, if each agrees to testify against the other, each will get a four-year sentence. In this hypothetical, each prisoner must determine whether he will betray his partner or cooperate with his partner by remaining silent.

The prisoner’s dilemma captures the situation that companies can find themselves in whenever an industry has two major competitors of nearly equal strength in the marketplace, such as Coca-Cola and Pepsi.

The dilemma is that Coca-Cola and Pepsi have two choices: each can attack the other, say through comparison advertising or aggressive price cutting, or each can choose to cooperate (without collusion, which is illegal) by going along with what the other is doing in the marketplace and thereby maintaining the market share division between the two. The problem is that each does not know what the other will do, so it is safer to go along with the less-than-satisfactory status quo than it is ideally to try to seize market share from the other.

Sotheby’s and Christie’s control about 90% of the fine art auction business. These two powerhouses have long been in a prisoner’s dilemma. Their answer was a six-year scheme to collude and fix commissions. The end result was a legal proceeding that in 2001 saw Sotheby’ former chairman Alfred Taubman sentenced to jail for a year and a day for his part in the conspiracy and there was a $512 million settlement to defrauded customers in a class action suit. This case became a topic for the television show Dominick Dunne’s Power, Privilege, and Justice.

The purchase of Fasig-Tipton in 2008 by Dubai-based Synergy Investments—a company headed by a close associate of Sheikh Mohammed bin Rashid Al Maktoum, the Prime Minister and Vice President of the United Arab Emirates and the Ruler of Dubai—is intensifying an already existing prisoner’s dilemma. Fasig-Tipton and Keeneland, like Sotheby’s and Christie’s, control the lion’s share of the auction market for Thoroughbred bloodstock. In addition, Synergy Investments has the monetary wherewithal to make Fasig-Tipton much more formidable.

One problem for Keeneland and Fasig-Tipton is that they are both competing with their own customers. In Keeneland’s case, it is competing against a company (Fasig-Tipton) affiliated with the best customer it has ever had, Sheikh Mohammed of Dubai. As for Fasig-Tipton, anytime it sells a horse to Sheikh Mohammed or his associates, it comes at the expense of the under-bidders, which means, ipso facto, that Fasig-Tipton ownership has deprived a customer. On the other hand,  if someone outbids the Sheikh or his associates, he or she has likely overpaid.

The long-term outcome of the prisoner’s dilemma in which Keeneland and Fasig-Tipton find themselves is problematic. Were you the chairman of Keeneland, would you accommodate your rival Fasig-Tipton by, say, leaving commissions at present industry-wide levels, or would you betray Fasig-Tipton by defecting from the arms-length arrangement and cut commissions, at least on certain highly coveted horses? The same question can be asked of Fasig-Tipton. Even if one acts secretly in discounting commissions, the penalty may be severe if the information gets out, which it very well may, as the competitor is likely to play a game of tit-for-tat and retaliate. Lower commissions leave both companies worse off (but are to the advantage of customers). Similarly, would you attack your rival in advertising and personal selling presentations, or would you refrain from doing so because you are unsure how your rival will react?

The answer to these kinds of queries is that in a classic prisoner’s dilemma, whether it be Coca-Cola vs. Pepsi or Fasig-Tipton vs. Keeneland, the greater likelihood is that a steady state will be maintained. Optimally, one firm would like to drive the other out of business but–uncertain what the rival will do–accepts a sub-optimal state of affairs. Keeneland would be very hesitant to act unilaterally, in say cutting commissions, without knowing how Fasig-Tipton would react, and vice versa. Collusion a la Sotheby’s and Christie’s is illegal and out of the question for moral and ethical executives, or for those who are tempted to collude but fear getting caught.

The prisoners in a duopoly will often be reluctant to do anything to rile up the opponent. However, there is the chance that Fasig-Tipton and/or Keeneland will defect from their arms-length understanding by betraying the other. In that event, the competition in the Thoroughbred auction business will become white-hot.

Copyright © 2009 Horse Racing Business


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