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Applying Game Theory in Procurement for Better Negotiations

By Kushal Babu
In Contract Management
Oct 31st, 2018
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Game Theory is a mathematical model of interactions that is used in competitive situations to settle conflicts or initiate negotiations between two rational decision makers. Game Theory is widely used in the fields of economics, politics, psychology, computer science and even biology. Game Theory was developed as a solution to zero-sum games where out of the two participants, only one would benefit. Business organizations use Game Theory to address issues like mergers, negotiations, product launch, price wars and more.

Negotiations between buyers and sellers are commonplace in procurement and often prove to be a tricky ballgame for both. Game Theory can be applied in procurement negotiations to achieve favorable outcomes and make strategic decisions. Although the procurement industry is well aware of the benefits of Game Theory in negotiations, its employment is still in the nascent stage.

Game Theory in Procurement- Explained                   

In order to understand the nature of Game Theory and its application in procurement, let’s consider a hypothetical situation between a buyer and a supplier.

Both the buyer and supplier involved in this situation are known as Players and the negotiation is called the Game. The prior information available to both the parties is known as Information Set and the plan of action that a player will take under different circumstances is known as Strategy. The payout a player receives at the end of the game is known as the Pay Off and the point at which both the parties reach an agreement is called Equilibrium.

Suppose one liter of fabric dye costs $100 in the market and that is the information known to both the parties. Let’s assume that the buyer’s maximum price offer is $100 and the supplier’s minimum price offer is $40. However, neither the supplier is aware of the buyer’s maximum offer, nor the buyer is aware of the supplier’s minimum offer. Certainly the buyer is expecting an offer that is less than $100 and the supplier is expecting an offer that is more than $40. Using Game Theory, both the parties try to get the other player to reveal their offers to place a counter offer. Suppose the buyer reveals the maximum offer and the supplier doesn’t reveal the minimum offer, the supplier will receive a payoff of $100 while he/she was ready to even accept $40. In another instance, let’s say the supplier reveals the minimum offer but the buyer doesn’t reveal the maximum offer, in this case the buyer will get away with a cheap pay off of just $40 when he/she was willing to go till $100. Both will fail to receive a pay off if either of them don’t reveal their offers.

Game Theory works under the assumption that the players are rational decision makers who acknowledge the information set and work towards equilibrium through mutual cooperation. Thus, Game Theory helps both the parties to reinforce confidence in one another and reach equilibrium by revealing their respective offers to settle at a common ground.

5 Benefits of Game Theory in Procurement

  1. Streamlines Negotiations
    Game Theory helps in making negotiations more structured by bringing both the parties on the same page. It adds more clarity to the entire process and ensures that both the parties commit to reaching an agreement as soon as possible while maintaining their respective interests.
  2. Increased Savings
    Buyers can take advantage of Game Theory to increase their savings, reap greater return on investments and explore new options to minimize their costs while retaining the existing suppliers. Game Theory makes negotiations more transparent in nature, thus offering a fair advantage to suppliers as well.
  3. Retain relationships
    Game Theory takes the interests of both the parties into account and thus both suppliers and buyers taking part in a negotiation will find its application helpful. The theory helps buyers retain their suppliers without paying high amounts and suppliers retain their buyers without losing much of their margins. It helps both suppliers and buyers to arrive at a middle ground and strengthen their existing relationship.
  4. Offers Deeper Understanding
    Given that Game Theory offers a systematic and scientific approach to reach agreements in a negotiation, it provides an opportunity for both the parties to analyze the reasoning they used to achieve the desired outcome. The reasoning and approach used to negotiate can be traced back, dissected, studied, improved and used again as a strategy for future negotiations.
  5. Better Procurement Practices
    Lastly, Game Theory helps in improving the processes involved within the supply chain. Improved processes can reflect in increased savings, shorter turnaround times, healthier supplier-vendor relationship and greater compliance.

Limitations of Game Theory

  1. Though Game Theory offers many benefits, it cannot be applied in all the situations. There are instances where rationality or diplomacy might not offer the solutions one is looking for. There are instances where mutual benefit might not be the most ideal outcome. During situations like this, one has to make the conscious decision of whether or not to use Game Theory to settle issues.
  2. Also, there is no hard and fast rule that the settlement reached using Game Theory should end with a mutual benefit. Though the theory adds structure and clarity to the negotiation, there are elements of uncertainty that might favor one party over the other.
  3. The assumption that both parties are going to be rational and cooperate with each other to reach a mutual agreement can prove to be risky. The theory assumes that both the parties won’t be hell bent on their self-interests while it may not be the case.

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