With this year’s award of
"The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel,"
a/k/a the Nobel Prize in economics,
to two masters of game theory, a brief recap of what game theory is and
what it means for managers contemplating and deciding on strategies is
in order.
"Game theory," roughly speaking, is the study of how people make strategic
decisions when interacting with others in conflict with them. Among
its more fetching intellectual attributes is that it can generate results
that at first blush are counterintuitive. A classic example is
Cortez’ decision to quite conspicuously burn his ships before engaging
in battle with the Aztecs: "What could he have been thinking?!"
is the reflex reaction.
He was thinking two things: (1) For the Aztecs, they interpreted
his bravado as confirming that Cortez was very optimistic indeed about
his chances in battle—for whatever reason that might be—and
were loathe to engage. And (2) for the Spanish soldiers, with retreat
not an option, their motivation to stand and fight furiously was redoubled. The
general form of this principle is, Sometimes limiting your options increases
your odds of success.
Still more generally, game theory recognizes that the theoretical model
of individual, rational, utility-maximizers operating in a static vacuum
is far removed from the real world, where utility maximization is only
one among several human motivations (including, importantly, preserving
self-esteem), and that actual decisions are made in a soup of others,
who are guaranteed to react dynamically and change the landscape in ways
perhaps not foreshadowed by one’s initial decision.
So, for managers, this means precisely what? That any strategic
analysis must include the likely reactions and counter-reactions of your
competitors, your clients, and even your own professionals and staff. McKinsey
discusses
this in the context of a duopoly chemical industry, where both
competitors are contemplating whether or not to build a new plant. In
a fashion vaguely analogous to the famous Prisoners’
Dilemma game, it appears to be in the interest of each company
to build their own new plant—if the other guy
doesn’t as well—it’s likely
that two new plants will be built, and
the industry will be left with excess capacity, loss of pricing power,
and a net decrease in profitability.
As McKinsey notes (the article is quite cursory), a full-blown mathematical
model-cum-solution is unnecessary for managers to benefit from the "what
next?" line of thinking that putting on one’s game-theoretic hat should
yield. The key insight is: "Look forward and reason backward."
If it’s good enough for the Nobel committee, it should at least be worth
considering by your executive committee.
