Game Theory in Business Applications - Case Study Example

Feryal argued that businesses are all about “interactions.” He d “in business, interactions with s, suppliers, other business partners, and competitors, as well as interactions across people and different organizations within the firm, play an integral role in any decision and its consequences”(1). Thus any decision by a firm has implications for many other players in the market and vice versa. The essence of game theory is, any strategy by a firm must take in to account the options available to other players. In the next section we will discuss the application of game theory in various business decisions. Pricing Decisions Pricing decisions by a firm cannot be made in vacuum. Firms decide prices in order to fulfill their objectives of revenue and profitability. Even a monopoly firm has to consider the pricing strategy from a point of view of its influence on others (non participants) in the market. Firms in monopoly markets may at times do not charge highest possible price as they fear that might bring in competition. In oligopoly market the decisions to lower or increase the prices are often determined by taking in to consideration the likely moves by the competitor. Thus a firm’s pricing decision is dependent on other decisions which are strategically determined. Thus game theory helps a firm in deciding the best price by considering the competitors’ likely changes in the prices. Firms in oligopoly, when indulge in price wars, end up with the same market share with no significant rise in sales but a sure reduction in revenues and profits. For example - In 2002 AMD slashed it prices just after the price cut by arch rival i.e. Intel. This reflected that company was not ready to give up market share even if it were to come at the cost of profitability. Thus Intel’s price cut could not bring excess market share to any of them but did certainly reduce their revenues. (“AMD cuts prices to match Intel”) This is an example of game theory problem called prisoner’s dilemma. Thus using game theory, firms can develop models to guide them in their pricing decisions. Advertising and Promotional Decisions When a firm considers an advertising decision, it aims at specific level of sales or market share increase. The effectiveness, of firm’s advertising and other promotional efforts is determined not just by the intensity of the promotional efforts by the firm, but it is also highly contingent on the decisions which are made by the competitors. If the competitors also run similar campaigns or more intense campaigns, the impact of the firm’s advertising and promotion will be nullified. In oligopoly firms often spend heavily on advertising with no significant gain in unit or revenue sales. The market shares also do not change. The firms ultimately restore the erstwhile equilibrium, however with a substantial hit in their profit figures. This is also an example of game theory problem called prisoner’s dilemma. Game theory offers sophisticated models that can be employed to deal with this kind of problems. For example – Cola companies, Coke and Pepsi spend considerable amount on advertising just to defend their market shares, with no rise in sales or profits. In fact their profit figures take a hit on account of heavy promotional costs. (Fruchter and Kalish 54) Research & Development Firms invest in R&D to gain new knowledge that they can utilize to gain competitive edge over their competitors. Firms, every year spend millions of dollars on their R&D efforts to gain undiscovered knowledge, formula, and process to take a quantum leap against its competitors. For example drug companies spend millions of dollars to develop better molecule but how much competitive edge the new molecule will offer to a firm will be determined by the actions being undertaken in the R&D department of the competitors. For example - if two firms are planning to invest in R&D both will be interested in succeeding first and getting it patented to thwart off the innovation by the other firm. In such a case the firms have to determine how their competitor will behave, which in turn will be determined by how intensely the firm itself spends on R&D. For formulating such interactive strategies, game theory may be of great use. Tender Bidding / Auctions In a tender bidding process, for the competing parties to decide the right quote to mention, they have to take into account the likely quotations by their other players in the game. This kind of game is of simultaneous moves, as the competing parties are not aware of what others are quoting. The application of game theory in such situations is crucial as the competing firms’ quotations depend on the quotations by other firms. Since none of the get to know what their competitors have quoted it makes problem all the more complicated and thus firms may have to develop several analysis to understand their competitors likely move in order to decide their own strategies. Entry in or Exit from a market The entry or exit decisions are made by considering the overall future scenario. Apart from the normal demand and supply considerations, the firm has to anticipate likely move by the competitors which in turn are determined by the moves the firm itself makes. Thus a firm, planning to enter or exit the market is in strategic relations with other firms. Thus whenever a firm is planning to enter a market it has to consider how the existing player may respond. The existing players may choose to be accommodating or aggressive, thus the best strategy will be determined by modeling the likely behavior of the existing competitors. For example - When Holland Sweetener Company realized that ‘NutraSweet’ patent was expiring in 1987 in Europe and in 1992 in The US. The firm thought of entering the Europe market in 1987, by building a plan in 1985. The firm was supported by coke, one of its future customers in both European and American markets, to launch its sweeteners. However firm’s expectations turned sore when it was confronted by its competitor, NutraSweet, which lowered its prices and was able to secure it contracts with both Coke and Pepsi. Its entry actually worked for Coke and Pepsi and not for itself, a failure to anticipate the likely move by other players. Had HSC applied game theory, it could have charged some money for this move as Bellsouth did (Brandenberger and Nalebuff 7). Production and Capacity utilization decisions How much to produce is often a function of price also along with other factors. Firms faced with the decision of how much to produce have to consider the likely production and price response by its competitors. Felix and Dennis argued that game theoretic reasoning can sometimes offer an insight which would otherwise be counter intuitive (8). They adduced an example of United B Company’s plant, which when sold by the company, benefitted the company. As without selling the plant it could have taken away sales from it competitor “Associated cement” which would have caused price war, but since now the competitor ill not fear competition from United B, it will not reduce the price and both the companies would benefit. This kind of reasoning would have not been possible without game theory application. Government Interventions Watkins argued that government affects businesses in so many ways that it is critical for businesses to consider the government’s influence in their strategies. The government influence may range from taxes and labour laws to antitrust rules, patents and copyrights etc. The games that businesses play, often involve government as players, rule makers and referees. Government can influence the result of the game by supporting or playing against any of the players (1). Mostly the games that involve governments are the ones in which a business is pitted against a public body, labour unions, independent small retailers associations etc. Labour unions and associations or other interest groups, by virtue of government support are able to influence the strategy of a business. Thus a business has to consider the role of government as a key player while making strategies. Thus game theory can be utilized in such situations: Labour negotiations, mergers and acquisitions etc. For example – In 1999, the proposed merger between Barnes and Nobles and the wholesale books group “Ingram”, fell through on account of, an all out lobbying effort by American book association. The FDC received many complaints against such a move by Barnes and Nobles, which finally led to Barnes and Nobles’ withdrawal from the deal (Watkins 2). Mergers and Acquisitions During the process of merger and acquisitions a series of negotiations takes place. The acquirer, the target firm, and other firms interested in acquiring the target or who want to thwart the merger are the players in the game. Thus any decision regarding the acquisition timing or pricing has to take in to account the likely move by the other players. For example - In 1989 the cell phone market in the US was witnessing consolidation; one Mr. Craig Mac-Caw was interested in taking over Lin Broadcasting Corporation. Lin’s CEO Donald Pels brought in another suitor Bellsouth to make Mr. Craig Mac-Caw pay much higher than his earlier bid. Had Lin not brought into Bellsouth, the bid would not have increased rather it had been lowered. In return to play its part just to increase competition in bidding BellSouth was able to earn $76.5 million. While considerable benefit accrued to Lin’s shareholders due to Donald’s strategy, taking into account how Mac-Caw would behave in response to competition (Adam and Berry 8). Supply Chain Management Feryal stated “companies act strategically not only in relation to their competitors but their supply chain partners as well” (5). Feryal further added that as each participant acts out of self interest the individual choices of each participant collectively; do not amount to an optimal outcome. The outcome will be optimal if the entire supply chain is managed in a centralized manner(6). Thus game theory approach in managing supply chain can offer great advantage. Adam and Berry adduced example of how Coke, supporting HSC to build up capacity in Europe to challenge NutraSweet’s monopoly, was able to bring down the cost of same NutraSweet sweetener just by adding one more player in the game(7). Thus game theory could be used in supply chain management. Capital Investment Decisions Ferriera, kar, and Trigeorgis stated that between 1995 and 2001 the annual revenue for the US chemical industry fell from $20 billion to $12 billion and the operating profits of the companies on an average dropped 26% from last year. The reason they argued, was the competition led poor investment decisions by industry players (1-2). In their pursuit of outpacing competitors in investment and capacity building to gain an edge over them, the players invested heavily. The result was overcapacity and piling inventories, which led to price cuts and thus eroded profitability. The decisions tools like NPV, PBP with such decision makers, although allowed them to calculate the profitability of an investment decisions in a static environment i.e. considering demand and prices as given for future years. Real options can help internalize the impact of price and demand change, but they also fail to capture the likely impact of competitors’ move. The competitors by their counter moves can thwart the investment objectives of the firm. Thus, for this situation, it was suggested Option games (Ferriera, kar, and Trigeorgis 9). Option games were developed by Smit and Trigeorgis, as a combination of Real options and Game theory. Thus game theory helps businesses by precluding poor investment decisions by taking in to account the likely moves by competitors also along with likely moves of demand and prices. References “AMD cuts prices to match Intel.” Brandenberger, Adam and Nalebuff , Berry. “Use Game Theory to Shape Strategy” Harvard Business Review Jul-Aug 1995: 1-20. Ferriera, jayanti kar and Trigeorgis. “Option Games: The key to Competing in Capital-intensive Industries” Harvard Business Review Mar-Apr. 2009: 1-9. Feryal, Erhun. “Game Theory in Business Applications” Management Science and Engineering 2003:1-65. Fruchter , Kalish. “Closed loop advertising in a Duopoly.” Management science 43.1 (spring 1997):54-63. Oberholzer-Gee, Yao. “Game Theory and Business Strategy” Harvard Business Review Mar 2007: 1-8. Watkins, Michael. “Government Games: Understanding the Roles of Government in Business Strategy” Harvard Business Review Jul 2002: 1-9. Smit, Han T.J. and Trigeorgis, Lenos . “Real Options and Games: Competition, Alliances and other Applications of Valuation and Strategy.” 2006. Read More