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Monthly Archives: August 2012

In its simplest form, prospect theory, originally pioneered by Kahneman and Tversky, explains why people make decisions to minimize loss rather than to achieve the highest expected value.

In a classic example consider two problems:

You are given $1000 and asked to pick one of two gambles:
A) 50% chance of winning $1000
B) $500 for sure

You are given $2000 and asked again to pick one of two gambles:
A) 50% chance to lose nothing
B) Losing $500 for sure

For the majority of survey respondents, in the first event they chose to gain $500 for sure, but when the event is framed as a loss, they chose to gamble. This is because of loss-aversion that is exhibited once you have a set reference point. The chance to avoid a loss becomes more tempting because we are so averse to losing once we have the $2000 in our possession even though the expected values of the gambles are identical.

Some day-to-day observations regarding leadership decisions while working in a public company seem to be neatly explained with prospect theory. Of these observations is the cultish obsession with revenue and EBITDA at my company. While financials reflect some measure of success, upper management has come to worship them as harbingers of life and death. One of the challenges that I have faced is the battle against upper management on whether to prioritize long-term goals vs short-term gains. In the losing battle I wage, I have seen time and time again a shift in prioritization from long-term progress to short-term goals. The idea of reference points and loss-aversion within prospect theory provide a possible explanation for these sub-optimal decisions.

Prior to an IPO, a company is often in a mode where they may be pre-revenue or unprofitable. A monetary loss may not be important and can be offset by a more intangible resource gain within the company.  Without public reporting, the reference point for the company is more fluid and changes with the needs of the company. The challenge of an IPO is that once a monetary reference point is set, these intangibles which may help the company in the future may become undervalued as they are not counted in the bottom line. The correct time for an IPO often comes when companies are growing the fastest and striving to become more profitable, exacerbating the possibility of missing projections and entering the realm of “loss”. In a public company, the focus is completely different with forecasting and quarterly announcements of targets. These promises become reference points set in stone for leadership and, when faced with the danger of missing the numbers, loss-aversion pushes decisions that will sacrifice anything to avoid losses. These initiatives tend to be ones that prioritize short-term revenue and padding while ignoring long-term impacts.

A second symptom of this creates an obsession with quantifying initiatives with a revenue/margin impact. This focus often de-prioritizes long-term initiatives because they often do not have immediate revenue boosts and are more resource intensive. Thus, by avoiding the losses based on a public reference point in a public company, leadership will trade the long-term gains for short-term value.

I believe that strong leadership is able to avoid these pitfalls, whether by understanding the economic concepts that drive their decisions, or by having a broader sense of what is good and bad for the company. As of yet I am still on the lowest rung of the corporate ladder; however, I do wonder if understanding these models can make us immune to their pitfalls. Perhaps that would be an interesting experiment to conduct!

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Through the years, I’ve come to develop a basic set of rules that tends to hold true for most game economies. Understanding general aspects of real world markets and combining that knowledge with that of a game economy allows for a good understanding of what to do and avoid in game markets.

Tenet 1:

In a factor economy understand the entire supply chain.

Frequent and dedicated trading is almost always easiest at the lowest level of a supply chain. The liquidity of these goods and the amount of available supply and demand is almost always highest at the lowest levels of the supply chain because these goods must be combined to create higher level parts. When trading these commodities, the entire chain of production becomes a possible exit point because you have to ability to undertake the crafting to convert that good into a product. This ability to convert the good as well as trade it allows for greater reward because of the higher possibility of arbitrage between the purchase and the many exit goods, as well as reduced risk because the good can be converted to another.

A caveat to trading low level goods is that there is a hidden value of most commodities in games that have crafting systems that is priced into the market. When crafting requires repeated creation of products using raw materials, the experience gained from the commodity is often priced into the material. Often this will result in the products created by these materials to sell for less than the inputs because of the value of experience. Being aware of the usefulness of the outputs and extra careful about the dollar value of experience will help in avoiding costly trades.

Tenet 2:

The more liquid the good, the smaller the margin.

Just as demand and supply are the highest for the low level commodities, the trading activity within these goods creates the most efficient markets. Because of the constant activity, spreads between the bids and asks tend to be small and thus the margins for trading these goods tend to be thin. One must be very careful when trading with low margins because the often overlooked costs of commissions and trading fees can often turn a profitable trade into one in the red. On the other hand, slow markets tend to have high spreads and thus offer the most opportunity for profit. One tactic when keeping this tenet in mind is that when one has time to dedicate to trading, they can pick highly liquid goods to trade frequently and increase profits; however, when one is not actively in the market, one can often invest in a few highly illiquid goods to effectively maximize the profit off of a single trade during the time that you are away from the market. One caution with this technique though is to be sure to pick markets with which you have a strong understanding. With illiquid markets, often the prices in market are very volatile because of the nature of players posting outrageous prices. One must have a lot of caution in picking their investment because this volatility usually regresses to the mean and thus profit opportunity will be lower than expected.

Tenet 3:

Always understand the origin of supply and the reason for demand.

Understanding supply for goods can help you foresee and take advantage of supply shocks or booms. In games, all goods can be traced to a specific origin. Understanding the amount of the good available and the relative rarity of the good can help with judgement of price and maximize your profit. Equivalent is understanding the reason behind demand. If demand is artificially inflated by some circumstance, investing in a good can be dangerous when the market crashes. This particular note is very salient in real world markets as well.

An example of this in action is an early demand spike for a highly rare item On the supply side, take for example a rare dungeon drop that is found early on in the game release. It is almost always good to sell that good immediately because supply will be severely constrained. As the game progresses, the rarity of the item will drop and the value of the good will stabilize at a lower value. The best course of action in this circumstance would be to immediately sell the rare good at a very high price (take advantage of the anchoring effect ;)) and then quickly reinvest the money into the market to beat inflation. Inflation early on in a game economy is a very real issue because of low currency saturation. As money is collected by the game population, money supply will grow quickly, and inflation will be high and unstable. In an established market, the urgency of these trades is much lower because of the relatively lower risk of inflation.

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These are just a few basic aspects that I keep in mind when thinking about a trade. After a while, most of these considerations become second nature and you will automatically understand when each of these tenets apply and what they might tell you about the good. Most game economies are only mildly sophisticated because of the nature of the market with many participants that are not engaged in actual trading and use the market purely as a tool to sell and buy. This gives the traders of any game a great opportunity to accumulate returns and ultimately those who are the most aware come away with the best earnings!