The Game theory behind GameStop saga
From reputable Wall Street bankers and hedge fund managers to the average Joe, everyone heard of GameStop. Long story put short, GameStop stock attracted short selling by big hedge funds, because the game retail industry had been declining as everyone now buys games online and uses steam downloading. The problem was that the stock was too much shorted, and some investors thought it was excessive. Individual investors responded by longing GameStop stock, saying that if they buy and hold the line, these mega hedge funds have to cover their short sales, a phenomenon known as short squeeze. A short squeeze occurs when a stock or other asset jumps sharply higher, forcing traders who had bet that its price would fall, to buy it in order to forestall even greater losses.
The situation GameStop was facing is an example Prisoner’s Dilemma. In which, there are three scenario: 1. the individual investors cooperate: All individual investors buy and hold the GameStop stock, and the hedge fund will lose huge amount of money as the stock price does not fall. The investors earn huge amount of money as hedge funds lose. 2.some individual investors defect but some cooperate: Some individual investors short the stock when the stock price is reasonably high, while other individual investors still buy and hold. Those who shorted stock exits with some profits while those who hold will be punished by falling stock price as hedge funds recover. 3. all individual investors defect: All individual investors short the stock, and the hedge fund comfortably recovers their stocks. All the individual investors reap benefit, but their benefit is less than it would have been if they had all held the stock for a long time for hedge funds to die out.
Individual investors have the incentives to cooperate by longing and not selling the stock, because this will drive up the price of the stock and hedge funds will not be able to cover their shorts, resulting in a huge loss (their loss is calculated by [the price at which they sold the GameStop stock] – [the price at which they bought the GameStop stock] If the stock price keeps going up, they will eventually go bust).However, they will not be able to cooperate if some individual investors defect by choosing to sell their stocks, giving other people more incentive to sell before the stock price drops further. In the short run, therefore, everyone has incentive to short the stock because if other investors short first, then he or she loses more. Individual investors started rebellion against Wall Street hedge funds courageously. While their intention is noble, economic theory shows that rational human beings are more prone to defect rather than cooperate. This phenomenon corresponds to the fact we learned in lecture — Nash Equilibrium in Game theory doesn’t always lead to the promising result for a specific party. From this example, we can see that when the number of people involved in the scenarios varies significantly, and the smaller group(with smaller people)might be included in the larger group, the smaller group is tend to not following the Nash Equilibrium and pursue for higher personal benefits.
source: https://bsic.it/the-game-theory-of-gamestop/