In the classic logic problem known as the prisoner’s dilemma, there are two prisoners, being held on a minor charge (such as breaking and entering) which comes with a 1 year prison term, suspected of conspiring together to commit a serious crime (such as grand larceny). There is little actual evidence to convict either of them and the police are relying on a confession by one or both prisoners to convict at least one of them of the more serious crime. In an effort to get this confession, the two prisoners are separated and each is offered an identical deal. The deal is that if one prisoner confesses, he’ll be set free, instead of spending 1 year in jail, and the other prisoner will get a 3 year sentence. If neither prisoner confesses, they each do 1 year, and if both prisoners confess, they will both serve time, but only 2 years each for coming forth. What should the prisoners do?
When the dilemma is analyzed using game theory, each party is most likely to betray the other and spend 2 years in jail rather than remain silent and enjoy the best possible outcome of only 1 year in jail. This is because, regardless of what the other prisoner chooses to do, each prisoner believes they improve their likely outcome by confessing, even though an analysis of the possibilities …
|P1 Confess?||P2 Confess?||P1 Sentence||P2 Sentence|
… indicates that each Prisoner is expected to do an average of only 1.5 years, and betrayal increases time served. Why? It has to do with something called the Nash equilibrium, which is a solution concept of a non-cooperative game where no player has anything to gain by changing only their own strategy (which is often the case when both players have to choose their strategy in secret) and results from the fact that the payoff relationships from each prisoner’s perspective make confession the only case where each player would do worse by unilaterally changing strategy. In simple terms, this means that if prisoner 1 chose confession and prisoner 2 chose confession, then either prisoner changing their choice on their own would result in that prisoner serving more time. In psychological terms, if you don’t confess, and your colleague does, you serve an extra two years while he walks free.
So what does this have to do with Supply Chain Finance (SCF)? Peter Loughlin does a great job making the comparison in his new Purchasing Insight paper on Demystifying Supply Chain Finance, sponsored by Taulia. Simply put, even though the best situation for many buyer-supplier relationships (where a SCF solution that would help both parties is not available) is the status-quo (of no supply chain finance), there is often an incentive for one party to choose a solution that benefits them, even though, as in the case of the prisoner’s dilemma, the choice of that solution often damages the other party considerably (by adding cost to the other party, just like the prisoner’s dilemma adds time).
The reason for this is that each primary SCF solution, for reasons that are clearly explained in the white-paper, has a sweet-spot and any relationship that falls outside of that sweet-spot isn’t helped by the solution, and may even be hurt by it. In a very cramped nutshell:
- Supplier Finance only helps large volume/dollar suppliers of large buyers because banks aren’t willing to bear the cost of on-boarding the long tail of the supply chain
- Dynamic Discounting only helps favoured suppliers because most buyers typically don’t’ have the liquidity to pay the entire supply chain early and not all suppliers have e- solutions that integrate with the buyers’ dynamic discounting solutions (assuming that the buyer will extend or negotiate terms across the entire supply base)
- Pre-Shipment Finance doesn’t help the buyer or give the supplier access to borrowing at the buyer’s creditworthiness
For more details, download Purchasing Insight’s new white paper on Demystifying Supply Chain Finance. It’s worth it.