Using Game Theory to Create Win-Win Supplier Agreements

By Kate Vitasek

No one plays to lose in life or in business. You’ve all heard the clichés and their infinite variations: “Win at all costs.” “Winning isn’t everything, it’s the only thing.” “Losing is for losers.” “Nice guys finish last.” “Second place is just the first place loser.” “Show me a good and gracious loser and I'll show you a failure.” “Show me a good loser, and I'll show you a loser.”

You get the idea. People play to win because giving-in or sharing doesn’t come easy.

But a win-lose approach is not effective when you are dealing with your largest and most strategic suppliers who also want to win too. The good news is there a much better way, one without just one winner, and one the increases the size of the pie for both the buyer and supplier. This article outlines some concepts grounded in behavioral economics—and game theory—that can guide companies to a better way to work with strategic suppliers, and by doing so enable them to shrug off that old ingrained win-lose, either-or business mindset.

Finding a True Win-Win Starts with the Right Mindset and Commitment

A true win-win approach requires effort and commitment by all parties. Strategic supplier relationships are neither an abdication nor a dictatorship. Rather, the most successful supplier agreements are ones where the parties act with a spirit of a highly collaborative partnership with regular, frequent communication to manage the expectations of everyone as well as the work.

A “Getting to We” mindset is the essential precondition, the philosophical mantra, if you will, that forms the architecture for a collaborative, trusting endeavor while keeping narrow, win-at-all-costs urges at bay.

The problem is that business people often have a blind spot when it comes to the notion of collaboration. Many organizations believe, and even boast, that they have solid partnerships in place. They brag about “partnership” and “win-win,” but in my experience and research at the University of Tennessee, I have found that individuals and companies often revert to selfish “What’s in it for Me” (WIIFMe) behaviors when push comes to shove. This is a natural instinct, seen all the time in almost every human endeavor. Many organizations train procurement and sales professionals in the art of negotiation tactics designed to give their organization leverage and a winning edge. It is exceedingly tough to change a mind-set to WIIFWe.

In order to be a true partner, the supplier must have a vested interest in being a competent and efficient collaborator in the company’s success. Forging a Vested relationship means the company and its service provider(s) must have a mutual commitment to each other—and each other’s success—over the long haul. The mentality must shift from an us-versus-them to a we philosophy, and that’s where game theory provides the foundation for that essential leap.

Game Theory and Behavioral Economics: The Science Behind a True Win-Win

Game theory validates the benefits of developing a win-win relationship.

Game theory attempts to model human behaviors, especially when there is an incentive at stake. Specifically, game theory attempts to model how an individual’s success in making a strategic decision depends on the choices of others. 

There are two types of games that can be played: zero-sum games and non-zero sum games. In the case of zero-sum games the size of the pie is fixed. For one participant to get more, other participants get less. In non-zero sum games, the size of the pie is not fixed; therefore everyone can do better, or much worse, depending on their interactions.

Deeply rooted in mathematics, game theory caught worldwide attention when John Nash, a Princeton University mathematician and game theorist, published his theory of equilibrium in 1950. It is commonly called the “Nash Equilibrium.” For this contribution Nash received the Nobel Prize in economics in 1994, which he shared with John C. Harsanyi and Reinhard Selten.

One of the core principles of game theory that Nash made famous—and the one that’s of particular interest to a Vested sourcing model—is the concept of equilibrium. In a game involving two or more players the Nash Equilibrium occurs when each player has chosen a strategy and no player can benefit by changing his or her strategy as long as the other players keep their strategy unchanged.

For example, Unilever and Wal-Mart are in equilibrium if Unilever makes the best decision possible, taking into account Wal-Mart’s decision and Wal-Mart makes the best decision taking into account Unilever’s decision. The two firms are in equilibrium if any unilateral change of one firms’ strategy does not result in any gains. Equilibrium is also referred to a solution concept. In essence, applying game theory develops a strategy that will optimize the payout. In brief, this means devising a strategy to play to win relative to the other player.

To be in Nash equilibrium does not suggest that all of the players have reached the best cumulative payoff. Each of the players’ decisions is dependent on the decisions the other players have made in the game. They might be able to improve their return, or they could all agree on strategies different from the Nash Equilibrium.

In other words, the power of partnerships, relationships and collaboration is not to accept the status quo, but to look for ways to change the game.

At the heart of game theory is the statistical rigor that illustrates what can happen when people play to win. Rational individuals will default to decisions that optimize for their individual best position. In simple terms, the natural tendency is to play to win for yourself, especially if the size of the pie is fixed (a zero-sum game). Game Theory models situations (“game rules”) and how people react to the rules in their effort to win the game.

By studying the rules of games and the reactions of players, game theorists have mathematically proven that seemingly innocuous rules can cause participants to do things to optimize the outcome, such as income, even when it might not make the most strategic sense.

So how to apply these lessons to when working with your strategic suppliers? One of the most common sourcing problems occurs when companies fall into the conventional trap of beating up their suppliers on price. They wrongly assume that they are operating in a zero-sum game and that the only way to make money is to extract it from the supplier base. The total gains and losses will add to zero. One side wins, one side loses.

This zero sum-game attitude is typical in conventional outsourcing negotiations. And that is why they fail to deliver the benefits that could be realized to all parties.

Collaborative Win-Win Games 

Modern game theorists have taken the concepts of game theory to new levels by applying the concepts to cooperative, or win-win, games.  Our work at the University of Tennessee has applied win-win thinking to large and complex sourcing deals – especially outsourcing deals where the buyer and supplier become deeply co-dependent on success.

A win-win game is one that is designed in a way where all participants can benefit. In economics this is the non-zero sum game. Robert Axelrod’s work helped put the concept of win-win game theory on the map in his book The Evolution of Cooperation. The book describes computer games with participants from around the world, focusing on determining how individuals in groups are likely to interact with others act in a competitive situation. These computer game simulations prove that when individuals cooperate they came out better than when they do not cooperate.

The lessons are simple but very profound: Playing a game together to achieve a mutual goal is always better than playing it with self-interest in mind. Working together towards a win-win strategy is always better than a win-lose strategy aimed at promoting self-interest.  

Let’s use an example of one easy-to-understand computer game that proves the concept. In the game there are two players and each plays 20 rounds of a game where they can choose to “cooperate” or “defect.” Each decision has a specific payout. If the game were played with the mindset to maximize winnings, the winner would be the player that earns the most amounts possible. When the winnings are looked at on an individual basis, when one player defects and the other cooperates, the defector earns $3 and the cooperator nothing. If both chose to cooperate, each earns $2. If both opted to defect, each earns $1. The game is played with each player pressing a button to determine if they want to “cooperate” or “defect.”  When looking at the total payout for a 20-round game, where one player always defects and the other always cooperates, the total game payout is $60, with one player winning everything and the other nothing, a very rare result when individual self-interest kicks-in. At the other extreme, where both players always defect or played to maximize their individual reward, the total game payout is $40, or $20 per player. However the most profitable strategy is when both players approach the game with a mindset of mutual cooperation from start to finish. In this case the total game payout is the highest, at $80 with each player earning $40.

The moral is that there is a risk each time a player becomes greedy for a little more. It makes the entire cooperative strategy fall apart and both emerge poorer.

In ‘win-lose’ terminology when both players cooperate the payoff is a ‘win-win,’ when one player cooperates and the other player defects the payoff is a ‘win-lose,’ and when both players defect the payoff is a ‘lose-lose.’

Contracts that that are written in the zero-sum mind-set are flawed structures that create inefficient contractual agreements and uneasy relationships.

Once this problem is recognized, smart business leaders will begin to think strategically about designing a win-win outsourcing solution with their most strategic suppliers so that all parties can work together for a better overall solution.   

Henric Häggquist, Microsoft’s senior director of the OneFinance outsourcing program, after the joint Microsoft-Accenture team won the Shared Services Outsource Network’s “Best Mature Outsourced Services Delivery” award, poetically said:

So why do we get these awards?

I say it is because of TOGETHER.

We face all things TOGETHER.

We win TOGETHER.

We face difficulties TOGETHER.

We never go YOU against US.

We have all seen what that leads to…

Working together for the win-win is more than a feel-good idea—it’s a necessity.