Leveraging 'Game Theory' in Strategic Sourcing

Sourcing managers who understand game theory gain deeper insights into the interests and objectives of participants


Even if outright collusion doesn’t happen, sellers might act in a way that sends signals to competitors, leading to higher prices. A similar outcome could result from acquisitions that eliminate competitors and reduce supply. Or sellers might restrict access by buyers, for example by devising narrowly segmented geographic regions. These forms of cartel-like behavior can occur even in the absence of any clear-cut oligopoly. Sourcing managers need to be alert to these changing dynamics in a sourcing game. One way to spot a possible cartel is to run a reverse auction in multiple rounds. Another is to shuffle the lots of an e-Rfx and check for consistency in bidding. Where bidders know one another’s price for the next round, the bids will most likely move in tandem.

When a buyer suspects collusion, is there some means of breaking the cartel? Changing the price settings might work. In a multi-round bid for contingent labor, for example, one round could set bidding for a management fee; another could ask for a minimum hourly commitment at a set price. Such tactics might throw the alignment among the cartel members out of kilter. It also helps the buyer triangulate the price structure of the service. This tactic can be useful in understanding margin structures in categories, even in actual price discovery. Another instance is that in a competitive bidding scenario, such as a reverse auction, non-binding games (where the buyer hasn’t committed to select the bidder with the lowest price) show more chance of collusion than binding games where the selection criterion is clearly spelled out and predicated on price alone.

A buyer who is new to the role or unfamiliar with the category can counter savvy sellers by mastering these techniques. A partner with deep expertise in sourcing strategy and procurement dynamics can help convert academic concepts into practical know-how. Many buyers mistakenly think game theory’s application is limited to the auction mode of negotiation. In fact, it works very well in multi-round bidding or even face-to-face negotiations. Even simple payoff matrices or “What If” scenarios are hugely helpful in designing negotiation scripts in multi-round negotiations. Astute sourcing managers are learning to apply game theory in these other situations. They also realize that inflated prices can happen not only in the simple oligopoly case, but also in other cartel-like behavior such as price signaling or industry segmentation.

Research shows that application of game theory payoff matrices helps buyers navigate all possible scenarios of the event outcome well in advance and select tactics accordingly to influence the most desired outcome. Before flagging off an event you should be able to predict the final outcome and work backwards to configure the rules of the game (in contrast to the business rules that bridle an e-Auction) for your desired outcome. Much like Six Sigma is designed to minimize variations in a process, applying game theory in strategic sourcing and reverse auctions aims to reduce the variability in the bidding process.

Down to the bottom line

Taken together, these broader views mean that game theory is not a mere novelty or niche tactic, but in fact has wide applicability. Game theory principles can potentially get 100 to 200 basis points more in a negotiation process over traditional techniques. What this means in $ terms is on a typical overall spend base of $1 Billion this could result in incremental savings of $ 6 million to $10 million.

Game Theory principles can be applied to at least 50 percent of the spend base across key verticals

To put these abstract ideas to practical use requires careful judgment about where and how they apply. One consideration is how much impact a given category has on the buyer organization’s financial performance: revenues, margins, and risk exposure. Another is the degree of leverage the buyer has in the supply marketplace, such as obtaining better commercial terms. Figure 3 shows how the criteria of impact and leverage affect different category execution models. Each model draws upon specific abilities and knowledge on the part of the sourcing practice.

For categories with low leverage, applying game theory techniques greatly helps where natural spend aggregation is not a very effective option.

The different models for category execution suggest the following guidelines for buyers. To leverage game theory with these techniques requires deep understanding and experience in sourcing from the buyer organization and its business partners.

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