insight GAME THEORY

VERSUS PRACTICE
More companies are using game theory
to aid decision-making. How well does it work in the real world?
50)

w
BY ALAN RAPPEPORT

MICROSOFT
announced its intention to acquire Yahoo
last February,
^ the software
^ HENgiant
Ml(knew the
strugglingsearch firm would not come easily
into the fold. Rut Microsoft had anticipated
the eventual minuet of offer and counter-
offer five months before its announcement,
thanks to the powers of game theory.
A mathematical method of analyzing
game-playing strategies, game theory is
catching on with corporate planners, en-
abling them to test their moves against the
possible responses of their competitors.
Its origins trace as far back as The Art of
War, the unlikely management best-seller
penned 2,500 years ago by the Chinese
general Sun Tzu. Mathematicians John
von Neumann and Oskar Morgenstern
adapted the method for economics in the
1940s, and game theory entered the academic main-
of peeling it back to its bare essentials." One popular
stream in the 1970s, when economists like Thomas
way to teach the theory hinges on a situation called
Schelling and Robert Aumann used it to study ad-
the "prisoner's dilemma," where the fate of two de-
verse selection and problems of asymmetric infor-
tainees depends on whether each snitches or stays si-
mation. (Schelling and Aumann won Nobel prizes in
lent about an alleged crime (see "To Squeal or Not to
2005 for tlu-ir work.)
Squeal?" page 36).
Game theory can take many forms, but most com- Many companies are reluctant to talk about the
panies use a simplified version that focuses executives specifics of how they use game theory, or even to admit
on the mind set oí tlic competition. "The formal stuff whether they use it at all. But oil giant Chevron makes
quickly becomes very technical and less useful," says no bones about it. "Game theory is our secret stra-
Louis Thomas, a professor at the Wharton School tegic weapon," says Frank Koch, a Chevron decision
of Business who teaches game theory. "It's a matter analyst. Koch has publicly discussed Chevron's use of
game theory to predict how foreign governments and
competitors will react when the company embarks
on international projects. "It reveals the win-win and

C F O IÜLÏ ÍA UGUST 2 t i l l II . C F O C O M 35
 gives you the ability to more easily play
out where things might lead," he says.
Ö.D HNIFK IHK MAIRIX
Microsoft's interest in game theory was
piqued by the disclosure that IBM was
using the method to better understand
the motivations of its competitors-
including Microsoft—when Linux, the
open-source computer operating sys-
tem, began to catch on. (Consultants
note that companies often bone up on
game theory when they find out that
competitors are already using it.)
For its Yahoo bid, Microsoft hired
Open Options, a consultancy, to model
the merger and plot a possible course
for the transaction. Yahoo's trepidation
became clear from the outset. "We knew
that they would not be particularly inter-
ested in the acquisition," says Ken Head-
rick, product and marketing director of
Microsoft's Canadian online division,
MSN. And, indeed, they weren't; the bid
ultimately failed and a subsequent partial
acquisition offer was abandoned in June.
Open Options wouldn't disclose spe-
cifics of its work for Microsoft, but in
client workshops it asks attendees to an-
swer detailed questions about their goals
for a project—for example, "Should we
enter this market?" "Will we need to eat
costs to establish market share?" "Will
a price war ensue?" Then, assumptions
about the motives of other players, such
as competitors and government regtiJa-
tors, are ranked and different scenarios
developed. The goals of all players are
given numerical values and charted on a
matrix. The exercise is intended to show
that there are more outcomes to a situa-
tion than most minds can comprehend,
and to get managers thinking about com-
petition and customers differently,
"If you have four or five players, with
four actions each might or might not take,
that could lead to a million outcomes,"
comments Tom Mitchell, CEO of Open
Options. "And that's a simple situation."
To simplify complex playing fields. Open
Options uses algorithms to model what
action a company should take—consid-
ering the likely actions of otiiers—to at-
tain its goals. The result replicates the so-
36 C F O l U L V í A U G U S T 20Ü8 . CFll
O Squeal or Not to Squeal?
Gaiiu' TIK'OIT in Atiion: in the classic example <»f
prisoner's dilemma, a sini^lc (oui se ol action has far diHerent
called Nash eqtiilibrium, first proposed
by John Forbes Nash, the Nobel prize-
winning mathematician portrayed in the
movie A Beautiful Mind. In this optimal
state, the theory goes, a player no longer
has an incentive to change his position.
As a tool, game theoty can be useful
in many areas of finance, particularly
when decisions require both economic
and strategic considerations. "CFOs wel-
come this because it takes into account
financial inputs and blends them with
nonfinancial inputs," says Mitchell.
RATIONAL T O A FAULT?
Some experts, however, question game
theory's usefulness in the real world.
They say the theory is at odds with hu-
man nature, because it assumes that all
participants in a game will behave ra-
tionally. But as research in behavioral
finance and economics has shown,
common psychological biases can eas-
ily produce irrational decisions.
Similarly, John Horn, a consultant at
McKinsey, argues that game theory gives
people too much credit. "Game theory as-
sumes rationally maximizing competitors,
who understand everything that you're
doing and what they can do," says Horn.
"7'hat's not how people actually behave."
(Activist investor Carl fcahn said Yahoo's
board "acted irrationally" in rejecting Mi-
crosoft's bid.) McKinsey's latest survey on
competitive behavior found tfiat compa-
C O M
isoner \ Prisoner
• 10 years
serves 6 j
months
goes free
Prisoner A: i
goes free : Each
_ i serves 5
É isoner B: : ^^^^
Q years j
nies tend to neglect upcoming moves by
competitors, relying passively on sources
such as the news and annual reports. And
when they learn of new threats, they tend
to react in the most obvious way, focusing
on near-term metrics such as earnings
and market share.
Moreover, finance executives have
their own sets of metrics, and when
favored indicators such as net present
value clash with game-tbeory models,
choices become more complicated.
"Sometimes [game theory] tells you
things you don't like," says Koch.
Game theory is still finding its place
as a tool for companies, and its ultimate
usefulness may depend on how quickly
it moves from novelty to accepted prac-
tice. Practice, in fact, may be key. Mc-
Kinsey takes that to heart with its "war
game" scenarios, in which a company's
top managers play the roles of different
parties in a simulation. In effect, this
boils game theory down to the school-
yard lesson that perfection comes
through repetition. "Discipline is not a
dirty word," as basketball coach Pat Ri-
ley once said. Game theory is one way
that companies can assess their options
with more discipline, CFO
ALAN RAPPEPORT (Al.ANRAPPEPORT®
CFO.COM) IS A REPORTER FOR CFO.
>••> For tnore Insights, go to
wwvv.cfo.com/insight s