Profit and loss sharing contracts as a prisoners dilemma: An agent based simulation with game theory application to participative finance

Abstract

PLS contracts, Like Musharakah in participative finance, represent a practice of profit and loss sharing contracts. It is claimed to be a fair economic mode of investment as it entails the sharing, by the participants, of profits and risks. This mode of financing, however, suffers from asymmetric information in the form of adverse selection and moral hazards. In this Agent based simulation we managed to apply a repeated game theoretical approach to PLS financing using an agent based simulation tool called Net- logo. The purpose is to test whether PLS contracts are representative of a prisoner’s dilemma game. We have identified different parameters which are used to calculate the payoffs of the bank and the enterprise which seeks financing. Each agent in this simu- lation has some strategies that he/she can use through the game. We have managed to run the simulation1000 times for different model parameters under each combination of the agent’s strategies. We have found evidence that PLS contracts are not represen- tatives of a a prisoner dilemma game as mutual cooperation does not lead to a better payoff to the corporation than mutual defection. Over a repeated process, however, we found simulation evidence that the threat by the bank to apply an unforgiving strat- egy towards defection, leads to a cooperative behavior by the corporation through the strategy Tit-for-Tats.

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“…Previously we tried to reduce asymmetric information between a bank and a risk-neutral corporate manager who requires funding a project costing F. He is endowed with personal wealth f and requires additional resources Ff to complete his project's funding requirement (Elfakir & Tkiouat, 2016).…”