Game theory has been one of those disciplines that have reached phenomenal status because it has introduced concepts and methodologies that are deemed by many to be “game-changers” (no pun intended). It first came about in the 1900s, and has been expounded on and progressed since then. However, there are still some questions and doubts on its applicability, especially in the real world and in real-life situations, particularly in daily business operations.
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In this article, we will start with the general definition of 1) the game theory, and continue then with 2) the game theory in day-to-day business.
THE GAME THEORY
But first, let us discuss what Game Theory is all about. It is essentially a discipline or a method of strategic thinking where the players will have to make decisions by looking from different perspectives, basically putting themselves in the shoes of the other players and anticipating their possible actions and reactions. The results of playing out these scenarios will be used to make decisions or choices.
When used in the context of business, Game Theory is most often used by business managers to figure out what their collaborators and competitors are thinking or planning. It has become a very powerful tool for predicting the outcomes or results of interactions or transactions among a group of players or competitors, where the action of one will have direct effects or impact on the others, and the others will react according to those actions.
What are the elements that compose Game Theory? There are three basic components at play here:
A set of players who are involved. In business, these often pertain to individual business managers and firms or companies.
A set of strategies which are available for use by the players at specific points during the game. This also encompasses the rules of the game, which are set in order to specify the sequence of all possible moves and actions. The information that are instrumental in strategizing are also covered here.
The outcomes for each possible set of strategies or actions, and the expected payoffs based on these outcomes. These payoffs are assumed to be known by all the parties or participating players.
Strategizing through the use of Game Theory requires several assumptions to be made. These assumptions are not fool-proof, however, since there are many arguments that could be made against them.
Assumption #1: All the players act and think rationally, making choices and performing actions that are in their self-interest. The weakness of this assumption lies on the fact that human nature does not often permit rational thinking, and humans tend to make decisions for reasons other than their own interests.
Assumption #2: All the players act strategically, while taking into consideration the responses of their competitors to their actions. This is also not always the case, because there are other drivers to players’ decisions, not necessarily the actions of others. In fact, many business managers even do not make decisions within the strategic context.
Assumption #3: The effectiveness of Game Theory is fully realized when all the players are fully aware of, and understand clearly, the payoffs – both the negative and positive ones – of their choices or actions. It is a fact that most players make decisions even without having all the information. Many even do not care to know the full story behind some actions or responses before deciding on a specific course of action themselves.
Game Theory can also be performed in two ways: simultaneous games, where the players make their moves or actions at the same time, without waiting for information on what the other players have chosen or acted upon, and sequential games, where the moves of the players will depend on, and in response to, the previous action or choice of another player.
THE GAME THEORY IN DAY-TO-DAY BUSINESS
Anyone that plays a key role in high-level and strategic decision-making in an organization should definitely consider learning about, and applying, the Game Theory. They include, but are not limited to, executives, directors, and senior managers.
The applicability of Game Theory may be in question by some pundits, but there is no denying the fact that even large and established businesses have openly discussed using Game Theory for their key strategic business decisions.
The most common situations where Game Theory becomes most useful include:
It is especially useful when it comes to analyzing first price sealed bid auctions. A first-price sealed bid auction is a type of auction where the bidders submit their bids – sealed and secured – and the highest bidder wins. What is analyzed are the behaviors of the bidders, and the factors that come into play when they make the decisions while preparing their bids. In this case, the bids are independent of each other, and are made by the bidders simultaneously.
Bargaining activities. Game theory also comes into play when bargaining takes place between or among parties. Examples include negotiations between management and the workers’ union, as well as revenue-sharing negotiations.
Product decisions. This is the quintessential area where businesses can “play games” or play out scenarios using the Game Theory. It is actually most frequently used by businesses in making decisions on whether to enter a market or to exit it. Businesses deciding whether to introduce a new product or not may also use a Game Theory.
Transactions between Principal and Agent. Principal-Agent decisions can also apply the Game Theory when tackling compensation negotiations as well as incentives to suppliers and business partners.
Supply Chain decisions. A huge bulk of the decisions made by businesses involves the supply chain, and some of the more common decisions made involve capacity management, make or buy, and build or outsource.
Importance of Applying Game Theory in Business
Making business decisions is a daily event for managers. They are always faced with decisions on what to produce, what to procure, and what to sell, followed by decisions on how much they should spend in producing or in procuring, and what price they should set when they sell. There are so many tools used to come up with decisions, and one of these tools is Game Theory.
We can enumerate several reasons why business managers should consider using the Game Theory in its business operations.
To reduce business risk. Simulations have been employed by business managers in their risk analysis methodologies. Applying game models is effective in determining equilibrium within the market. Risk analysis makes use of Game Theory in determining optimal price strategy, expected market shares, expected income and number of customers, while obtaining information about the company, the market, the competitors, and the technologies in use, among others.
To obtain insights regarding the competition and the overall competitive landscape of the business and the industry. One of the best ways to be competitive is to know your competition. Using Game Theory is very effective in getting information on the various factors related to the competitiveness of the business. The core addresses the question “what are my rivals or opponents thinking?” They want to know what their competition’s next move is – their motivations, their strategies, their strengths and their weaknesses, and use all these information to change the game and increase the value of their own business proposition.
To improve internal decision-making processes. By playing out business scenarios, companies become more confident in their decisions, and management is more inclined to have greater involvement in the internal decision-making processes.
Business managers must beware, however, of how they use Game Theory. It is not a management tool that they can use as a substitute for experience in business. It is merely a tool, or a guide, for them to go about their tasks or roles as business managers.
Game Theory applied in Pricing Decisions
The pricing decisions of a company can be highly influenced by the pricing choices or decisions of rival companies. One popular example was the price-chopping decisions initiated by Intel and Advanced Micro Devices (AMD) on their desktop and mobile processors.
Intel and AMD are considered to be competitors in a highly specialized niche, and both are in a tight race to gain a larger share of the market. The first move was taken by Intel, who initiated a price slash on its desktop and mobile processors. AMD reacted by implementing a similar price cut, even if it meant potential losses or decrease in revenues.
This price war resulted to both companies seeing significant increases in unit sales and shipments of their products – a sign of an increase in their market potential. However, their revenues saw a drop, and so did the profits.
The concept of ‘Prisoner’s Dilemma’ is apparent in this example. Prisoner’s dilemma is best represented by a situation where two criminals, who are accomplices, are interrogated in two separate rooms. The interrogators are not in possession of sufficient evidence or information to make a conviction, so they have to find a way to facilitate a confession. They present each of the suspects with two choices: either defect, or confess to the crime and get a lighter punishment or jail sentence, or they could cooperate, or refuse to say anything, and suffer the punishment due them.
The interrogators make it a point to inform both suspects that the other is fully aware of the deal and its connotations. Thus, each of them will make a decision without knowing what the other’s actions will be.
If the two suspects decide to defect and make a confession, they will both get the full brunt of the punishment and be sentenced the standard jailtime. If, however, one suspect confesses and the other stays quiet, it is the latter who will get the jail sentence – often even longer – while the one who confessed gets off with a lighter sentence, or even walks away scot-free.
In the AMD and Intel example, AMD reacted with a price slash of its own after Intel made the move first. But what followed was a series of price cuts that could only be described as a “repetition of interactions”. Both companies are aware of each other as long-time competitors, and that they will be playing the same game for a long time to come. Thus, they have the choice on whether to cooperate with each other and kept their prices higher, or they could engage in mutual price-chopping actions.
Game Theory applied in Supply Chain Design Decisions
Many assume that Game Theory applies only to getting the pulse of competitors. However, it can also apply to the relationship of companies with their supply chain partners. Supply chain management can be facilitated by Game Theory concepts.
The game can be played in one of two ways. A non-cooperative game is where the players are unable to make binding commitments before making a choice or deciding what strategy to implement. On the other hand, making such commitments is possible in a cooperative game, which means that players can form coalitions and make side-payments.
Let us say, for example, that there is only one wholesaler of Product A. All retailers will source their inventory from this single supplier. If there is more than one supplier, however, it becomes a different ball game altogether. There are now two suppliers competing for product availability. If the first supplier has unavailable stocks, or are unsatisfactory, the retailers can turn to the other supplier. The payoffs enjoyed by the two players will differ, dependent on several factors such as demand, price and customer satisfaction.
Taking into account the Game Theory assumption that all players are acting on their self-interests, it is important to note that their individual choices, when taken as a whole, do not always mean that the supply chain is optimized, or that it is able to enjoy an optimal payoff. Consider the fact that there are multiple players, or companies; this means that the supply chain is decentralized. If you compare it to a centralized chain, with only one or two suppliers, there is a significant difference between the profits. Obviously, the profits in the decentralized supply chain will be lower than that of the centralized chain.
Game Theory in Managing Shareholder Value
A performing company is able to provide value to its stakeholders and shareholders. In order for the company to perform well, top management – all the way down to the rank-and-file – are expected to pull their weight. It is a collective effort, as all are working for everybody, instead of one group focusing on its own compensation without care for the others.
Game Theory has been applied in efforts to create compensation schemes that effectively align the interests of all stakeholders of the company: the managers and the workers (the agents), and the shareholders (the principals).
It is a given that the shareholders do not have direct control over the actions of the managers and the workers of the company. They also cannot directly monitor them. That does not mean, however, that they are entirely helpless. By offering incentives, they can have a say – albeit indirectly – on how the managers and the workers should act. These are commonly seen in the relationships between real estate agents and prospective property and home buyers, and that of franchisees and franchisors.
Through Game Theory, we are able to get more than a glimpse of the interactions of agents and use the information obtained in making strategic decisions.
Game Theory in Making Entry and Exit Decisions
Entrants to new markets are faced with many questions and dilemmas. This is a decision so huge that a significant amount of research, information-gathering and analysis is required.
Say, for instance, that Company B is looking to enter a new market in a South American country. Currently, there is one similar firm – Company A – operating in that market. Company B’s decision-making process would consider the following:
Will Company B make a profit once it enters the market? How will Company A react to the entry, and will the reaction affect the potential profitability?
How much investment will entering the market require from Company A? Will Company B’s reaction affect the investment costs?
Company B will have to consider all the possible reactions of Company A. Company A can choose to welcome Company B, letting it get a share of the market it used to solely own. Or Company A can choose to start a price war with Company B, cutting its prices in order to maintain its stake on the market.
Through Game Theory, Company A can decide whether it would be accommodating to Company B, or if it would be aggressive. Drawing a game tree using the information available in order to see what strategy would be most beneficial or have the bigger payoff.
Granted, Game Theory might not be the best or most recommended analysis tool out there for businesses, but no one can deny its usefulness when it comes to day-to-day business operations. Business operations revolve around strategies and interactions – essentially a “game” – and this discipline tackles a game that involves a strategic interaction between players, with outcomes and payoffs waiting at the end.
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