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However, if both participants in the game operate under the philosophy of "Minimize the total jail time served by both parties", the rational response is to never cooperate.

A strategy where every prisoner keeps mum, thereby satisfying the above requirement, can be successfully invaded by a cheater (defector), who avoids 3 years of jail time by tacking another 17 years on to his partner's sentence. It's no skin off his back.

When cheaters make up 25% of the population at large, your expected jail sentence from defecting is 0.75 * 0 + 0.25 * 10 = 2.5 years, still lower on average than the 3 years of mandatory time for the lesser charge. At a 50% incidence of cheating, the average sentence is 0.5 * 0 + 0.5 * 10 = 5 years, which is longer than 3, but shorter than the 0.5 * 3 + 0.5 * 20 = 11.5 average term for the non-cooperators.

At every point along this continuum of 0 to 100% defectors, defectors have shorter jail terms, on average, than non-cooperators. In behavioral ecology, this is referred to as an "evolutionarily stable strategy", or ESS. In essence, an ESS is a strategy that can not be unseated by alternative strategies once it has been adopted by the majority of players, even if the overall fitness of the population suffers as a result.

When cheaters are identifiable and subject to retaliation (which in the "prisoner's dilemma" game of ex-cons, is probably a given), then you can have other optima based on conditional probabilities (i.e. the "tit for tat" solution that solasis mentioned).

Buffett and Munger have repeatedly recommended Richard Dawkins' "The Selfish Gene" at their annual meetings. If you want a good, albeit simple, intro to this sort of thinking, I highly recommend it.

Obviously, Wall Street is way more complex than any simple game theory models. But you might think of passive indexing as the non-cooperation strategy, active investing to beat the index as the defector strategy, and frictional effects (translating into a drag on GDP) as the cost paid by everyone.


P.S. to solasis: Hope I'm not behaving like an annoying stray dog following you over here. But you're producing these amazing sand-painting posts for nobody, and I feel compelled to comment before they get washed away. BTW, good call on USG--I've already written it down to 0.
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