Want Better Procurement Outcomes? Apply Game Theory

Even if you’ve never heard of game theory, if you’ve played a board game that requires strategic thinking, trades, or payoffs, you’ve undoubtedly used it before.

For example, in chess, you’ve most likely sacrificed lesser valuable pieces like pawns in exchange for more strategic positioning to set yourself up for future moves. Toward the end of the game, you’ve maybe even sacrificed more valuable pieces like your queen in order to put your opponent in checkmate.

This is game theory — anticipating a strategic interaction from another player and moderating your choices accordingly based on the choices before you. In procurement, game theory can be applied to one party’s strategic advantage (or mutual advantages between suppliers and buyers) in myriad ways. Arkestro’s Predictive Procurement Orchestration platform employs the use of game theory to apply these principles to real-life situations where millions in potential cost savings, not chess pieces, are on the line.

This blog dives into what game theory is, how Arkestro applies it, and why game theory success stories have turned the discipline into such a hot topic for procurement professionals.

Understanding Game Theory

Game theory is a study and mathematical framework of how and why independent parties (or players) make decisions based on their interdependent situations. When two players are competing, game theory is the science examining the strategy behind the decisions of both parties. 

While a relatively new discipline (it was formed in the 1940s), game theory has become one of the most important and useful tools for analysts when considering strategic decision-making in applicable scenarios from competitive markets to negotiations to, yes, procurement. For anything where a player’s strategy must consider the potential choices and reactions of others, game theory can be applied. Here’s how it works. 

Core Elements of Game Theory

Game theory always includes these fundamental components: 

• Players: These are the decision-makers in the scenario. There must be at least two or more parties involved and the outcome will depend on the players’ decisions.
• Strategies: This includes the plan of action or possible actions each player will take depending on the scenario’s circumstances.
• Payoffs: The outcomes or rewards each player receives based on the combination of strategies chosen by all players. This can be dollar amounts or benefits in other forms, such as utility.
• Information: What each player knows when making their decisions, which may or may not be complete or accurate.

Nash Equilibrium and the Prisoner’s Dilemma

Two important concepts related to how game theory is applied include the Nash equilibrium and the prisoner’s dilemma. 

Nash Equilibrium

The Nash equilibrium represents an outcome where no player can increase their payoff by unilaterally changing their strategy. In other words, it’s a moment where, based on the existing conditions, neither player has regrets about the outcome based on the payoffs or consequences. It’s impossible to predict the outcome in isolation; rather Nash’s equilibrium demonstrates that choices should be analyzed through the lens of what each player expects the other to do.

Prisoner’s Dilemma

Next, the prisoner’s dilemma is an application of Nash’s equilibrium through the example of two prisoners being questioned in isolation for a crime. The two prisoners are presented with several choices: cooperate with each other (don’t confess), cooperate with police and thereby work against each other (one confesses to achieve a better outcome than the other), or both cooperate with police (both confess). A key element is that neither prisoner can know the decision the other will make, so they must act according to what seems the most rational due to their current situation and the information they have.

The prisoner’s dilemma demonstrates how competing self-interests and rationality impact decisions, and how all decisions are dependent on the context and information each player has.

Game Theory Applied to Procurement

These theories apply to procurement in a variety of scenarios. For example, consider auctions — game theory can predict bidding behavior when suppliers submit bids in a sealed-bid auction. Variables such as number of bids, market conditions, and risk profiles can impact how high or low the bid ends up being. 

Another example is price negotiations. While negotiations may seem like a “zero-sum game” where one party benefits over the other, they can actually become mutually beneficial if game theory is applied. Understanding the optimal price for procurement while also considering the supplier’s cost structures and negotiation leverage can lead to better relationships with suppliers.

How Arkestro Applies Game Theory

At the end of the day, suppliers are human. Each interaction with suppliers in procurement is an opportunity to apply game theory and behavioral science to influence better outcomes. For example, the final price is often higher when the seller makes the first offer vs. when the buyer takes the lead. Applying game theory is one of Arkestro’s five main pillars behind predictive procurement, alongside data science, dynamic supplier feedback, pricing theory, and intelligent automation. 

By providing line-level suggested pricing and dynamic feedback, Arkestro generates a sense of competition for each supplier sourcing request, even those for single or sole-source suppliers. This creates a sense of scarcity or fear of missing out (the payoff vs. the consequence) among suppliers and automatically suggests the outcome to the supplier without requiring any manual intervention on the part of the procurement team.

Concepts like the Nash equilibrium and the prisoner’s dilemma are also applied to foster optimal pricing and post-award compliance among suppliers. Setting an anchor offer with a starting price at the item level is an example of the prisoner’s dilemma — now the supplier has to decide whether to take the contract or gamble losing it to the market. By immediately providing responses and alternative offers and by relying on the human aversion to loss, Arkestro’s PPO speeds up the negotiation process and secures more favorable terms. 

What does the application of game theory mean in terms of output and productivity? On average, Arkestro’s customers experience 16% savings from historic baselines and run three times the number of events with the same headcount. Teams reach more spend to obtain better outcomes, faster, and at scale.

Leveraging Game Theory for Success

When it comes to strategic sourcing, automating negotiations, and improving procurement decisions at scale, game theory is a crucial key to unlocking success. In a post-pandemic world where procurement has had to rethink how they engage with vendors and suppliers, game theory provides a smarter framework to apply existing data and make more strategic decisions.

For example, Provisur Technologies, a food processing equipment company with a large global presence, applied Arkestro’s PPO and game theory to their procurement processes to great impact. Provisur saved $350,000 across four campaigns, an average of 20% per event, by driving internal competition and innovation among buyers. This led to wins for both suppliers and Provisur — Provisur processed $2.6 million in spend through Arkestro and suppliers were able to grow their business as well.

Arkestro isn’t just another platform promising better results; it’s the only platform that leverages this innovative and proven approach (check out the patents here)! Reach out to learn how Arkestro’s use of game theory can improve your team’s procurement outcomes.