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chalkExcerpt of an interview with Nobel laureate Robert Aumann*:

Q: Game theory as a subject seems to have been rarely applied to real business situations. To what do you attribute this?

Prof. Aumann: That is absolutely incorrect. Game theory as a subject is very often applied to real business situations. There is a tremendous range of applications of game theory, both cooperative and non-cooperative. Game theory has been applied to law, auctions, matching markets, and all kinds of things. Let me just mention, for example, the matter of matching people to jobs, which is a tremendous field in which the prominent people are Alvin Roth, Marilda Sotomayor, David Gale, and Lloyd Shapley. There is also the very hot new topic of matching kidney donors to patients who need a transplant, in which game theory has been highly effective. Let me also mention something completely different, such as the issue of how to charge for telephone calls. In large organizations, such as government offices, universities, and corporations, they place a large number of phone calls. Although these days this is very cheap you still have to pay for it. And the question is how to do the charging, and this is something that is a matter of cooperative game theory. The first work on that was done by Billera and Heath in the late 1970s. There is a whole field called industrial organization, which is largely a matter of game theory. There is a tremendous amount of game theory that goes into the design and the question of strategy choice in auctions, for example. Around ten years ago, the U.S. Congress decided that it was no longer going to give away electromagnetic frequencies and that they wished to start auctioning them off. There was a big auction for frequencies that were to be used for cellular phones, called the “Spectrum Auction,” and the Federal Communications Commission (FCC) hired game theorists to design the auction. Communication corporations used other game theorists to advise them on their bidding strategies. This auction was a tremendous success for the FCC and the government. They were expecting U.S.$500 million and they actually got almost one hundred times that. They got U.S.$45 billion dollars out of this auction, and that is because of game theoretic design. The range of applications of game theory to real business situations is simply enormous, so what you suggest with your question is absolutely not the case.

Q: Then allow me to reword my question in another way. Are you happy with the proliferation of game theory in real business?

Prof. Aumann: Of course I am happy. It is an applied science, absolutely. It is amazing how useful it is, and for all kinds of things, such as traffic, arbitration, auctions, etc. There is a lot of useful work. Let me give you another example of how game theoretic principles have been applied to business. Let’s look at the example of “final offer arbitration.” In most arbitrations you have, say, an employer and the union, and they are fighting over a wage contract and the union threatens to strike. Let us say that after a long period of shadow boxing they agree to binding arbitration, where the union and the employers will present their demands (i.e., how much they are willing to accept or pay). The arbitrator will listen to both sides and he will usually arrive at some sort of a compromise, depending on how convinced he is of the merits of the cases that are presented by the two sides. So, what are the incentives in this case? The incentives are for both sides to exaggerate their claims. Let us say that the union is satisfied with a payment of 85. However, they know that if they ask for 85 they might get less, so they ask for more, just like in any other bargaining situation. So they ask for 110. On the other side, the employer might be willing to pay 65, but they also know that if they offer 65 they might end up having to pay more. So they offer 45. As for the arbitrator, his range of decisions has now become enormous, and that is not good for either side. Now there is an alternative scenario that has been suggested by game theorists, called “final offer arbitration,” which essentially means that the arbitrator is not allowed to compromise; he must choose one of the two positions, exactly as they have been presented by the different parties. Some might question the logic of such a process, since many believe that the arbitrator is there in order to compromise. But look at the incentives that this creates. The incentives are now the opposite of what they were in the classical kind of arbitration, because now each side is motivated to present as reasonable, as moderate, a claim as possible. If the union claims 110 and the employer decides to go to 65, the arbitrator will realize that given the details of the case, 65 is much more reasonable. The arbitrator cannot increase that, so he would award 65. Consequently, the union will decide not to make an unreasonable claim, and may even be willing to claim a little less than what it really wants. As a result, the offers of both sides would be very close to each other and the arbitrator will not have much work, as he will choose one of the two sides. The implication is that both sides become more truthful, and perhaps even a little more forthcoming. This is a very simple application of game theory, but it explains the basis of game theory, and that is to build a system where the sides have an incentive to do what you want them to do; in this case you want them to agree to be as close to each other as possible and give the arbitrator as much information as possible.

*Journal of Financial Transformation, April 2007
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