An analysis of supply chain politics can benefit from applying game-theory concepts extensively. Game theory, according to the Stanford Encyclopedia of Philosophy, studies the ways in which strategic interactions among rational players produce outcomes with respect to the preferences (or utilities) that none of those players might have intended. In simpler terms, game theory tries to explain the results of interactions between people or groups whose motives are opposed, or at least not identical. As used here, "game" is a metaphor for any human interaction: from war, to politics, to business.
During the past five years, the idea of Game Theory has entered popular culture, most notably in the book and film A Beautiful Mind. The applicability of game theory to supply-chain management is just starting to be recognized. In this analysis of the dynamics of supply-chain relationships, I use a game-theory exercise known as the Prisoner's Dilemma.
In the Prisoner's Dilemma game, two imprisoned suspects are questioned separately about a crime they perpetrated together. The two suspects have a choice: Each may give evidence against the other, or both may say nothing.
If both say nothing, they receive a slap on the wrist and are freed due to lack of evidence. If one gives evidence of the crime and the other says nothing, the first goes free and the second is severely punished. If both give evidence, both are severely punished.
The overall best strategy for the two suspects is for both to say nothing. However, not knowing what the other will do, each prisoner's individual best strategy is to confess and present evidence, which is the worst possible outcome for the two of them.
The suspects' dilemma here is that, no matter what the other does, each is better off confessing than remaining silent. However, the result when both confess is worse for each than the outcome if both had remained silent.
Game theorists use this exercise to study conflicts between the self-interest of individuals and the group. A group whose members pursue what seems to be sensible self-interest may end up worse off than a group whose members act contrary to rational self-interest.
The supply chain prisoner's dilemma
A game theory analysis using the Prisoner's Dilemma exercise shows that cooperation typically is not the best policy when it comes to relationships between OEMs and EMS providers. Consider how the profits would be split between an OEM and its EMS manufacturing partner in a $100 million outsourcing deal for a consumer electronics product. The chart below presents the trade-off between profitability and the level of cooperation in the OEM/EMS relationship. The term "open" describes the level of cooperation between the OEM and the EMS provider.
Under favorable circumstances, the OEM would like to achieve a 5 percent net profit after tax (NPAT) on the $100 million it would receive in revenue from the product. The EMS provider might deliver as much as 70 percent of the cost of the product, hoping to make a 2 percent NPAT if all went well. These two profit percentages appear in the upper lefthand box in the chart.
If the OEM could convince the EMS provider to shoulder all the costs of expediting, inventory obsolescence and other tasks, then the OEM could increase its profit by almost an equivalent amount as the profit lost by the EMS company. In other words, the OEM could increase its profits from $5 million to $7 million, while the EMS firm's profits would drop to zero. That would be a good deal for the OEM but a terrible one for the EMS company.
These profit percentages are presented in the upper righthand box of the figure. This situation would take place when the OEM was "closed," i.e. non-cooperative, while the EMS partner was "open, " i.e. cooperative.
On the other hand, if the EMS provider somehow convinced the OEM to do all its planning, to pay for its obsolete inventory and to let it keep rebates it receives from suppliers, then the EMS company could double its profits while eliminating most of the OEM's. The profits in this situation are estimated in the lower lefthand box.
Finally, if both the OEM and the EMS firm expend time and money battling over every expense, profits will be halved for the EMS company and reduced by 40 percent for the OEM. Although a cooperative, "open" relationship clearly produces the most combined profit, it is neither the EMS provider's nor the OEM's best strategy.--D.L.