How useful is game theory in understanding business organisations strategic behaviour in the real world? Essay

How useful is game theory in understanding business organisations strategic behaviour in the real world?

Game theory presents a number of important insights into strategic behaviour in a competitive business environment. The theory provides a taste of the issues that can be addressed. By means of a two-firm framework it ruminates how common and recurring business decisions can be analysed as games in the real world. It also shows that by such means numerous complex problems can be rendered tractable. Game theory has many aspects to it of which includes its beneficial side in aiding strategy formulation.

The conduct of businesses in a competitive environment it seems is sometimes, in some ways, similar to a battlefield. In the business environment, the firms can be viewed as the mercenaries, whilst the competitors are given the distinct delineation of the enemy, and the outcome of this theoretic rendezvous may be of an incurable nature to one side or the other. The question is whether the competitive environment of businesses in the real world, like in the battlefield, is best approached with the assistance of some sort of strategy?

In fact the increasing importance of strategy encourages the need to make some sense of its usefulness in the real world. For example, a situation may arise involving two firms – say Vodafone and Orange – leading and rival mobile phone operators. The two firms may be faced with a one-off decision that involves the coincidental and independent selection of a certain level of advertising expenditure for a new service. That is to say each firm does not have the opportunity to observe the selection made by the rival, or to co-ordinate plans. The pay-offs to each firm in terms of market share, profits etc, can arise from possible choices in game theory.

If both firms choose not to advertise, then the resulting pay-offs can be high for both. If one firm, say Orange, advertises while the other adopts a high risk strategy and does not, then the outcome of success for Orange can be very high in comparison to the outcome for Vodafone which can be low and vice-versa. But if both operators advertise, then the outcome can be medium for both. This being the maximum (safe) strategy of: –

“… choosing the policy whose worst possible outcome is the least bad”

(Lecture Handout)

In such a scenario both will indeed advertise each reasoning that if it advertises while its rival does not, then it obtains a very high outcome. On the other hand, the outcome to each when both advertise (medium) is greater than that obtained by either (low) if it does not advertise when the rival does. It follows that both operators advertise irrespective of the choice made by the competitor.

Advertising is a dominant strategy for both firms in such a tight oligopolistic market as the mobile phone market. Unfortunately, the implementation of such strategies does leave the incumbents with lower pay-offs than the high/high, which they could have obtained by agreeing to desist from advertising.

The above example shows the advantages of being the first mover in certain situations, as in the case of firms who dominate or have a large market share. Game theory can also aid in the introduction of new products or services as done by O2, another mobile operator. The firm, not a dominate incumbent in the market at present, was the first company in the world to launch and rollout a commercial GPRS (or 2.5G) network and has also secured third generation mobile telephony (“3G”) licences in the UK, Ireland and Germany. The implementation of such a strategy left this incumbent with higher pay-offs because of the choice of a maximum (high-risk) strategy of: –

“… choosing the policy whose which has the best possible outcome.”

(Lecture Handout)

Interdependence is the core of an oligopoly such as the mobile phone market. The paramount supply decision of, for example, O2 will depend on guessing how the rivals in the market will react to it’s own actions. Therefore demand curves depend crucially on how rivals behave and can be induced to behave. In introducing a new product or service an operator such as O2 will need to contemplate whether or not Orange, Vodafone and T-Mobile will follow a parallel strategy.

On the other hand if a new operator entered the market by offering cheaper product or service, hoping to initiate a price war it’s future will depend on how an incumbent operator like 02 will react. The reaction may be collusion with the other three main operators Orange, Vodafone and T-Mobile in lowering prices further to drive the competitor out. This is another side of game theory that can assist firms and also help to understand business organisations strategic behaviour in the real world.

The usefulness of game theory in understanding business organisations strategic behaviour in the real world is highlighted in another example where the threat of a new entrant into the market can be addressed through competition and collusion. If a new operator enters the market then strategic entry barriers like collusion can be made in boardrooms involving the dominant firms of an oligopoly. They occur from genuine pre-commitments to counter entry if confronted, therefore influencing the entrants’ option in favour of oneself by affecting the entrants’ outlook of how incumbents will behave if challenged. An example of this is the airline industry where Laker broke into the market in 1970 offering cheaper fares, but they miscalculated the reaction of the other airlines who colluded and went even cheaper to propel it back out of the market.

It is in fact very difficult to implement game theory into the real world, yet in an oligopolistic market like the mobile phone market, interdependence is the core, and the paramount supply decision of for example O2 depends guessing how rivals in the market will react to it’s own actions. This is where interdependent decisions can be made using game theory.

In an oligopoly such as the mobile phone market the players in the game are the operators, their payoffs are their profits. A strategy can be chosen, which could entail collusion – to maximise joint profits. In the long run the consumer would probably be the one who benefits most.

In addition to the benefits of game theory the negative aspects include cheating to maximise payoff for the individual company. Due to the complicated nature of the game and difficulty in implementing it into the real world for incumbents of a market, such as the mobile phone market, for MMO2, Orange, Vodafone and T-Mobile the optimum strategy to choose could be to collude and create Nash Equilibrium. Yet the temptation to cheat or switch from one strategy to another is great, therefore underlining the tension between collusion and competition.

The usefulness of game theory in understanding business organisations strategic behaviour in the real world is raised when analysing decisions made as in the following example. MM02 in 2001 by initiated SIM locking which could prevent consumers from switching to different operators. The remaining three players Orange, Vodafone and T-Mobile didn’t wait too long in showing their hand. Here it seems the strategy of MM02 was of a maximum (high-risk) strategy where choosing the policy which had the best possible outcome. The desired result was to create a barrier in the market itself of preventing consumer switching to another network through SIM locking. The risks were indeed high as this may have pushed the consumer away when the contract between company and consumer was finished; yet the same strategy was adopted from the other operators hence the threat was seen to have been nullified.

Other common applications of game theory include pricing decisions, i.e. when to lower price of products, investment decisions, i.e. the sponsorship of Manchester United Football Club by Vodafone, predatory pricing, i.e. when there is a threat in the market, discrimination, marginal cost, joint maximising, etc. A recent example of game theory’s usefulness in understanding business organisations strategic behaviour in the real world could be the manoeuvre of outsourcing.

Recently HSBC Bank in the U.K. outlined plans to move call centres to countries such as India, thus cutting 4,000 jobs at its UK customer service centres over the next three years. HSBC’s decision reflects a growing trend among UK firms to move customer support and call centre jobs to Asia to cut costs. British Telecom followed suit with plans to switch its directory enquiries service in India, as did insurer Prudential last year. HSBC is looking towards the far east and India to supply future growth, hoping to take a bigger slice of the country’s 1 billion-strong population’s banking business. Though a high-risk strategy due to the backlash of trade unions in the U.K. the advantageous outcomes are clear – cost cutting, lower paid workforce, lower sunk-costs, in general vastly lower overheads.

In the sometimes perplexing business environment, managers have to devise dynamic new systems to assist them. These systems must give managers a way of analysing the impact of conflicting, sometimes contradictory market forces.

They have to help managers change direction as the environment changes, as is the case with HSBC Bank.

All of this must be done at the present time, so that the organisation remains limber enough to move at exactly the right strategic moment-and not a moment later.

Game theory seems helpful in analysing decisions with the benefit of hindsight. But is it much help in the heat of battle? It does seem to present problems in the implementation of it . Some of these problems lie in the links between a company’s strategy and its internal capabilities. Game theory and various models like the Beach Location Game, the Prisoner’s Dilemma etc are very hard to use in complex environments – the “chopstick problem” and the “Collage problem”, where: –

“Models form an incoherent collage suggesting no general principle”

(Lecture Handout)

As of yet formal games models like the ones mentioned have not been able to improve on expert judgement as greatly as hoped. Also game theory does not show exactly how strong the forces are for collapse or collusion, this could be due to in some cases a large number of firms in a market. An example could be the sports market where market leaders like Reebok and Nike despite a large market share are still challenged by smaller chain stores i.e. Soccer sport, JJB, T.K. Max and also the likes of Sainsbury and Tesco supermarkets that are also selling sportswear amongst their clothing range. Any collusion by the market leaders could result in huge losses and price wars due to the complexity and number of firms in the market.

This is why for market leaders such as Nike and Reebok collusion and/or price competition is largely shunned due to the fear of the unpredictable consequences of price changes and the knock-on effects. Instead certain tools are used such as advertising (non-price competition) i.e. on buses, newspapers, catalogues, radio and television. Better quality products and services are presented and various marketing strategies i.e. winter and summer wear, kids and adult wear, internet shopping the sponsorship of sporting events etc are used to create a customer bond, loyalty and goodwill.

Nevertheless, this does not mean a decline in the future importance and development of game theory. It has been the influencing factor in many different cases over the years including in 1994-95 it influenced the design of the $7 billion auction of radio spectrum for mobile phones in the U.S., the influence of it in the mobile phone sector in the U.K. In World War II British navy officers first applied game theory to the deadly serious pursuit of trying to outwit German submarine commanders. Other real life examples range from the social behaviour of pigs, the salaries of sportsmen/women, politics, the Iran-Iraq war to bidding for Olympic games broadcast rights.

The Game of Chicken

&

Military Intelligence

#1: Please divert your course 15 degrees to the North to avoid a collision.

#2: Recommend you divert YOUR course 15 degrees to South to avoid a collision.

#1: This is the Captain of a US Navy ship. I say again, divert YOUR course.

#2: No. I say again, you divert YOUR course.

#1: THIS IS THE AIRCRAFT CARRIER ENTERPRISE, WE ARE A LARGE WARSHIP OF THE US NAVY. DIVERT YOUR COURSE NOW!

#2: This is a lighthouse. Your call.

BIBLIOGRAPHY

www.emerald insight.com –

Rothschild, R. Senior Lecturer in Economics in the Management School at Lancaster University, Lancaster, UK

Management Decision, Volume 33 Number 9 1995 pp. 24-29.

Business as a War Game: A Report from the Battlefront

Fortune

30 September 1996 (Vol. 134 No. 6).

Lecture/Seminar Handouts.

Lecture/Seminar Notes.

McAleese, D (1997), Economics for Business 1st Edition, Prentice Hall Europe, Hertfordshire, Part 1 – Chapter 6.

Begg, D et al (1991), Economics 3rd Edition,

McGraw-Hill Book Company (U.K.) Limited, Berkshire, England, Part Two – Chapter 10.

Picture is from www.yahoo.co.uk

www.yahoo.co.uk

www.econ.canterbury.ac.nz