From the Nobel Committee to You

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.