Transaction models such as e-auctions or online marketplaces have expanded buyers’ toolkits. Some of the most sophisticated tools come from game theory. Although their source is an established body of academic literature, the research findings are not being applied to full effect in business. One reason the theory has such potential is the way it models conflicting and cooperating goals that vie for influence in transaction negotiations. Where academic research regards these as abstract "behavioral permutations," buyers and sellers feel the actual cut and thrust.
Sourcing managers who understand game theory gain deeper insights into the interests and objectives of participants. How can they bridge the gap from theory to practice, and which findings are most applicable? This paper explains the applications of game theory—basics of the approach/principles, practical real life instances where the theory plays out in sourcing events, and some ground rules buyers can follow to enhance leverage of this concept in day to day buying.
Fundamentals of Game Theory and implications in the Sourcing context
Game theory is behind the scenes in many familiar situations: for example, a poker game where the next call, raise or draw is contingent on how the player expects opponents might respond. A few of the theory’s concepts, such as the “winner’s curse” or the “prisoner’s dilemma,” have found their way into popular discourse. One glaring example of winner’s curse comes from the telecom industry. In an auction for wireless spectrum, incumbent telcos bid up prices far beyond the value their business could support. The unlucky winners suffered for years afterwards from heavy debt loads and low return on capital.
The prisoner’s dilemma illustrates the equilibrium concept at the core of the theory. Two people imprisoned for the same crime are interrogated separately; they can either confess or remain silent. Because of the way the consequence depends on the other player’s (unknown) action, apparent self-interest leads each player to confess. This is the equilibrium outcome, even though both players would have ended up better off with a different strategy.
Payoff matrix for the simplest form of Prisoner’s Dilemma
Because of mutually competitive mindsets, both prisoners confess and the game reaches equilibrium in the right bottom quadrant (see Fig. 1) where the interrogator (buyer) wins. A similar payoff matrix results in various forms of sourcing events where game theory applies.
A buyer can structure an analogous situation by negotiating with two sellers independently. Suppose they have comparable financial strength and similar cost structures for a commoditized product. The lowest price each is willing to quote will be the same, at a minimal profit margin. If the bids are not converging, the buyer’s tactic is to continue the negotiation by revising the floor price progressively. If the bids do converge, this is a sign that the prisoner’s dilemma has played out. The bid pattern aids the buyer in price discovery even when supply market scenarios and price structures are fluid. This is especially helpful in the indirect space where not many categories are indexed and easy to track.
All the cards on the table
Real life is not always as simple as the game implies, of course. Two equal bids might instead be the result of collusion between the sellers. If they are part of a known cartel, game theory won’t apply since it works best in “oligopolistic” situations. This could have a bearing on certain indirect categories like advertising and marketing services as a result of continuous supplier rationalization and supplier stickiness factors. Certain commodities can also become cartelized because of changes in industry structure leading to formation of consortiums. As an example, the market for copier paper shrinks and marginal manufacturers exit, leading to greater concentration. Fewer players mean greater alignment of interests and easier opportunity to collude.