Open Options wouldn’t disclose specifics of its work for Microsoft, but in client workshops it asks attendees to answer 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 regulators, 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 situation than most minds can comprehend, and to get managers thinking about competition 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 — considering the likely actions of others — to attain its goals. The result replicates the so-called Nash equilibrium, 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 theory can be useful in many areas of finance, particularly when decisions require both economic and strategic considerations. “CFOs welcome this because it takes into account financial inputs and blends them with nonfinancial inputs,” says Mitchell.
Rational to a Fault?
Some experts, however, question game theory’s usefulness in the real world. They say the theory is at odds with human nature, because it assumes that all participants in a game will behave rationally. But as research in behavioral finance and economics has shown, common psychological biases can easily produce irrational decisions.
Similarly, John Horn, a consultant at McKinsey, argues that game theory gives people too much credit. “Game theory assumes rationally maximizing competitors, who understand everything that you’re doing and what they can do,” says Horn. “That’s not how people actually behave.” (Activist investor Carl Icahn said Yahoo’s board “acted irrationally” in rejecting Microsoft’s bid.) McKinsey’s latest survey on competitive behavior found that companies 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-theory 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 practice. Practice, in fact, may be key. McKinsey 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 schoolyard lesson that perfection comes through repetition. “Discipline is not a dirty word,” as basketball coach Pat Riley once said. Game theory is one way that companies can assess their options with more discipline.
Alan Rappeport is a reporter for CFO.