Many organizations adopt game theory based on its value during the procurement process. The challenge is understanding which projects to shortlist, particularly those in regulated sectors.
This article outlines a 7-Step pilot selection process to help you select your first game theory for procurement project.
Game theory is a set of mathematical methods that help analyze strategic interactions between two or more players.
Besides analyzing strategic interactions and identifying the optimal behavior of each player, mechanism design, a subfield of game theory, has been used to design rules that generate desired behaviors from participants, such as truth-telling or minimal prices.
Game theory and mechanism design have proven to be particularly useful in purchasing negotiations. They help procurement managers increase their negotiation power and lead to significant savings by transforming the nature of the interaction from buyer vs. supplier to suppliers competing against each other.
In procurement, applying mechanism design and game theory usually means developing a negotiation as a set of rules (a mechanism – typically involving multi-round negotiations) that determines the winner of a contract and ultimately leads to cost reductions.
While public procurement and other regulated industries certainly have fewer degrees of freedom in designing a procurement negotiation, game-theoretic optimization is often possible while staying fully compliant with relevant regulations.
When choosing a game-theory project, there are several critical metrics to consider based on the nature of demand, the structure of the market, and project management.
For a quick visual guide to these criteria, please check out:
The Game Theory Pilot Selection Process
1- Start with a high-value negotiation
A procurement project should have a sufficiently large volume to be suitable for game-theoretic optimization.
On the one hand, the expected savings need to justify the effort. On the other hand, suppliers should be keen on winning the contract. Both aspects tend to work out well when the expected purchasing volume exceeds 4 million EUR/USD.
2- Consider the specification and complexity
The result is often difficult to specify in advance when purchasing creative services such as marketing, design, and other professional services. The provider will typically detail the specification as part of the service. A game theory project requires a sufficiently precise specification of the good or service to be purchased.
Also, look at the complexity of the negotiation. When complexity is higher, game-theoretic optimization can play out its strengths and create significant value.
3- Select a negotiation with enough competition
Game theory shifts the dynamic of the procurement negotiation from buyer vs. suppliers to suppliers competing with suppliers. While there are also approaches for negotiating monopolistic suppliers based on behavioral economics, leveraging competition requires at least two suitable suppliers where volume can be shifted between them.
Shiftability measures the degree to which procurement can purchase goods or services from different suppliers in a specific contract. While ideally, you would have full shiftability between all suppliers, there are usually some restrictions either by the suppliers‘ capacity or the willingness of internal stakeholders to accept certain suppliers.
4- Select a negotiation that is attractive for suppliers
Before taking part in a procurement tender, suppliers weigh their cost of participation against the expected benefit. A negotiation based on game theory may initially seem unusual to suppliers and require additional effort. The extra cost of involvement needs to be offset by the expected benefit. In other words, the contract needs to be highly attractive to suppliers. In most cases, this criterion is met through a high-volume negotiation, but it is recommendable to look at each participant’s motivation individually.
5- Is the market driven by cartels?
A cartel refers to often illegal cooperation between suppliers to fix prices, divide market share between them, or agree on a bid rotating scheme, where the winner of a tender is predesignated.
Cartels raise prices by 25% on average.
There are powerful strategic and tactical concepts that can help break up cartels. We have designed several game-theoretic procurement negotiations that have broken up cartels and reduced prices by up to 40%.
Note: To learn more about our game theory services, please click here:
Artificial intelligence can support identifying cartels. We have helped several customers implement innovative and effective cartel detection methods based on artificial intelligence and procurement bidding data.
Suppose you suspect that cartels influence the market you consider for game-theoretic optimization. This is an essential input for the project as a specific approach may be required to tackle the unwanted coordination.
6- Support from internal stakeholders
Discuss readiness to switch suppliers with internal stakeholders. The more open your internal customers are to switching between suppliers, the fewer barriers there are to establishing a fully competitive, game-theoretically optimized approach.
A successful game theory project also requires a commitment from top management to stick to the defined mechanism and the outcome of the negotiation, which is determined autonomously by the mechanism.
Committing to the defined process is crucial for the mechanism to unfold its effectiveness. Top management will only commit to an autonomous procurement mechanism if it supports, understands, and trusts the game-theoretic approach.
Ensuring commitment is, in fact, often easier in regulated industries as the applicable regulations require laying out the process and adhering to it.
7- Select a procurement project several months in the future
Since the setup of a game theory negotiation typically requires more effort than a traditional procurement project, you need to plan extra time for preparation.
Ideally, you would look at procurement projects at least two months in the future. Early involvement of procurement and game theory experts increases freedom in setting up a negotiation and improves results.
Game theory’s effectiveness in procurement has almost become common knowledge.
The first step to implementing a game theory project in procurement asks for a strategic decision of the CEO, CFO, or CPO to conduct a pilot project.
On that basis, the project team can identify suitable projects for sure. The screening criteria give you a good indication of whether a project is ideal for game-theoretic optimization. You can find our visual guide in the link below, where the steps outlined in this article are summarized.