Playing it for real: Nobel Prize forces business to take game theory seriously

COMPANIES compete, make moves, score points. They demand level playing fields, play their cards close to their chests, and put businesses into play. They gamble on new products, and depending on their skill, they win or lose.

Business terminology is full of game jargon. So it is surprising that the corporate world has largely ignored an economic theory dealing with the strategies of game playing - at least until three proponents of games theory won the Nobel Prize for Economics last week.

Invented by John Von Neumann and Oskar Morgenstern in 1944, game theory was first applied to practical questions in the fields of international politics and warfare. The Rand Corporation, a US think- tank, made it famous during the Cold War by using it to work out the doctrine of mutually assured destruction.

The awarding of last week's prizes to John Nash of Princeton University, Reinhard Selten at the University of Bonn, and John Harsanyi, at the University of California, Berkeley, could spark broader interest in the technique.

Dr Nash's contribution to game theory was the concept of equilibrium. He showed that a wide class of games reach stability, says Professor David Newbury of Cambridge University.

Nash equilibrium is best known in various forms of the Prisoners' Dilemma. Two burglary suspects will go free if neither of them confesses. But if one squeals, he will get two years in jail while his partner will serve 10. It may seem counter-intuitive, but the best move for each 'player' is to rat on his accomplice. That way they will each only have to do two years behind bars.

Dr Selten looked at multi- stage games, where the credibility of a threatened move makes a difference. For example, Widget Manufacturing might threaten to slash its prices if Gadget Products enters its market. If Gadget stays out it neither gains nor loses, while Widget keeps all the profits. But if the rival does join in, Widget would have to choose whether to share the market or exercise its threat. If slashing its prices cost it more than sharing the market, the threat is not credible and Gadget should ignore it.

Dr Harsanyi went even further, using the mathematics of probability to work out strategies when several different games are possible. He, too, concentrated on the academic side, using the theory to understand and explain events in the real world. But there is also a role for games theory as a tool to help executives make decisions.

Take the battle that is shaping up between Eurotunnel and the cross-Channel ferry companies, Sealink and P&O, says Dr John Kay, a visiting professor of economics at the London Business School. Once the Channel tunnel is fully open, Eurotunnel is expected to grab market share by offering cheaper crossings. The ship owners are likely to retaliate with discounts of their own.

But game theory, taking into account the lower marginal cost per passenger on trains, predicts that the price war will eventually stabilise. 'The only Nash equilibrium is one in which the tunnel aggressively undercuts the ferries,' says Dr Kay.

The theory can also be used to predict the outcome of joint ventures. If they involve an exchange of information, the best strategy is to cheat - take as much as you can but do not give anything away. A company that does that will win if its partner plays straight, and draw if its partner cheats, too, but it won't lose, Dr Kay says.

If the companiesinvolved are trying to achieve a shared objective, however, game theory predicts they will co-operate. 'That's why the US and Russia were able to co-operate to defeat Hitler but couldn't play a successful disarmament game,' he says.

Another area where companies could benefit from game theory is knowing when to quit. British Satellite Broadcasting could have packed in a year earlier, saving shareholders pounds 100m, if games theory had been applied to its fight with Sky TV, says Dr Kay. The theory would have shown them that Sky's commitment to its technological standard was so strong that BSB's challenge was not credible.

Games theory does not always work, and one of the tasks for consultants trying to apply it in the business world is to determine when it is appropriate. Says Dr Kay: 'It's a tool to let you think in a much more disciplined way.'

(Photograph omitted)