Game Theory: "You Talkin' To Me?"

If you're at at all like me, you've read more than your share of interesting articles about game theory, and you love the notion in the abstract, but you've never figured out exactly how it could apply in the real world—make that, your world.

I'm not saying I can change that, but I'm game to try.

"Game theory," in essence, is the acknowledgment that your actions, tactics, and decisions will affect the behavior of your competitors and colleagues:  It is the classic "dynamic" rather than static analysis.   For example, if a basketball team fields a star player, the opposing team's efforts to contain him may leave other team-mates unusually open, so even if you (the coach) anticipate the star won't get too many shooting opportunities, you could still decide to field him for the benefit, as it were, of his spillover effects.

Original game theory research focused on "zero-sum" games, because they're mathematically simpler.  Zero-sum games are those, as you probably know, where one side's gain is the other's loss.  Business, of course, is anything but a zero sum game, and perhaps that's why it's taken a few decades for game theory to move from the ivory tower of the academy to, at least tentatively, the real world.

Introducing Barry Nalebuff, a Yale economics professor who is also a businessman on the side, as founder and CEO of the $10-million/year in revenue "Honest Tea," a sort of Snapple for the Whole Foods crowd (where Honest Tea is indeed the biggest seller in that category).

Nalebuff has also taken himself out of the ivory tower, so to speak, in his consulting work to Fortune 500 firms.  As explained in this "Strategy + Business" article ("Strategy + Business" is Booz Allen's thinking publication):

"Then, while consulting to Fortune 500 companies in the mid-1990s, Nalebuff developed his method for applying game theory in business decisions. The process begins with writing down and categorizing all the elements of a game: the players, the rules (e.g., laws and government regulations), people's perceptions, the boundaries of the game (the market), and the linkages among all the elements.

"With that level of detail in hand, the player then spells out the consequences of a change to any of the elements. The approach helps CEOs make better strategic moves by offering a more complete picture of the consequences of their decisions. More importantly, says Nalebuff, it can help leaders understand the games of their industry well enough to reframe the business.

“‘Philosophers have only interpreted the world. The point, however, is to change it,'” Nalebuff says. “Karl Marx said that, and I am probably one of the few professors who still quote Marx, but he had a point: The action is in changing games rather than playing games.”

But the real value of his approach is in what I promised to attempt at the outset: Concrete techniques for applying some of the insights of game theory to actual business decision-making. Here they are:

• Imagine you have all the power and money in the world.  When looking at a problem, imagine there are no constraints.  Silence your internal editor, silence the scold that keeps piping up with negativity, and imagine you could supply your client (your partner, your practice group) exactly what they want. He uses the example of Donald Trump getting wrong-number calls from an automated fax machine in his hotel room at 2:00 in the morning.  Donald would hire an apprentice to answer the phone.  Your lower-cost solution might be to route all calls directly to voicemail without ringing. 
  
  I'll give you a more real-life example I heard about today from the GC of a Fortune 50 company:  Pretend a client in the midst of an M&A deal is facing a Hart-Scott-Rodino "second request," which would be painfully time-consuming and might even derail the deal.  You tell them your firm can proceed on two tracks at once:  Use your $700/hour partners with expertise in this area and contacts at the DOJ to argue why the second request is unnecessary, and also deploy a platoon of associates and paralegals to begin the document review just in case.  Since yours is a premium firm, the document review won't be cheap, either.
  
  The client balks at the price.
  
  Try this: Disaggregate the associates' document review from the partners' DOJ arguments. Charge full freight (or full freight plus) for the partners who actually do have the irreplaceable expertise, but outsource the document review to Bangalore or to West Virginia.
  
  Just a thought.
  
• Second, re-examine incentives.  I promise you will find some that are poorly designed, and should be corrected.  This can require creativity, but it will be rewarded in spades.  Nalebuff's example here is the deadly business model Blockbuster Video first inflicted upon itself:  Buying videotapes from the studies at $99/copy, meaning its breakeven was 50 rentals per tape.  Result:  No stock, dissatisfied customers, Blockbuster version 1.0 on the ropes.  The "incentive change?"  Negotiate a deal to pay only $10/tape, but share $1.00/rental with the studios.  Result:  Blockbuster 2.0 could offer ample inventory, no late fees, far higher customer satisfaction and profits.
  
• Three:  Perform the thought experiment of turning things upside down.    His example here is Priceline, which asked why airlines and hotels should be able to set their prices and wondered what would happen if buyers could set the prices.  Result:  A $1+-billion company.
  
  Trust me, this is one thought experiment not mentioned by Booz Allen, but it's one of my own, and one of my favorites:  How different do you think the world would look if the odds were 50/50 that the man or the woman would be the one to end up pregnant?  The repercussions would of course extend from pre-pre-K to the boardrooms of the Fortune 500 and the AmLaw 200.
  
• Four:  (Less germane to law-land, frankly, but let's indulge the fellow)  Ask yourself where else a product, a service, or an idea might work—particularly if the first rollout is less than world-beating.  He doesn't offer this example, and I'm making it up, but suppose your firm has developed a conflicts-checking system at no small expense that's actually very good at uncovering relationships between your lawyers and potential engagements.  What if you turned that on its head and adapted it to uncover relationships between your associates and specific areas of expertise they should have by year X but in fact don't?  Wouldn't that change your assignment system? 
  
  The point is to re-use, re-imagine, and re-envision assets you already have in place.

Let me conclude with a (literally) bet-the-company technique Nalebuff used when negotiating with seed money investors in "Honest Tea:"

"The formula with which Nalebuff and Goldman capitalized the company was pure game theory. Normally, startups have to gin up a valuation for a company that doesn't yet exist. “Rather than try to defend something that we pulled out of thin air, we created a valuation that was based on our subsequent performance,” Nalebuff says.

"The early investors came in with a zero pre-money valuation, but the founders got warrants at two times, three times, and five times valuations. Once the stock price doubled, the initial investors would be diluted. Once they had tripled their money, they would get diluted again. They would be diluted one more time when they had received five times their money. Nalebuff had created a contingent valuation. The effective initial valuation ultimately depended on how well Honest Tea did.

“The game theory lesson here is that when two sides disagree about something, rather than try to convince the other side that you are right, agree to a bet,” Nalebuff says. “If we did as well as we hoped or expected, then our initial valuation would prove to be high. But if not, then we would not dilute the initial investors.”

Remember that lesson from game theory next time you're counseling a start-up on valuation.