“The Train Wreck That Is Strategy” and Game Theory

23 May 2006 at 1:34 pm 10 comments

| Nicolai Foss |

In a comment on my co-blogger’s post of yesterday, a commentator argues that there is no real alternative to formalism, and then provokingly continues:

If you need any demonstration of the need for formalism in theory-building within the social sciences, take a look at the train wreck that is Strategy. As we are discovering using formal methods, most of what passes for foundational theory in strategy is wrong.

Unfortunately, he doesn’t explain what exactly he means by “foundational theory in strategy” and why it is “wrong.”

I think that formalization is definitely an important goal of social science research and is worth striving for (See Patrick Suppes’ very convincing argument on the “desirability of formalization in science”). Formalization certainly also makes life easier in a number of ways. For example, in my teaching I have found it literally impossible to convey what agency theory is fundamentally about without using game theory.

However, what may be at issue is exactly how important it is and, in connection to this, whether the practice of building formal theory per se should occupy the highest position in the reputational hieararchy of economics.

With regard to the last point, it is debatable how much of real economic substance new growth theory has added to growth theory relative to earlier theorists (see this paper). It is also similarly debatable how much game theoretical IO has really added relative to the earlier informal observations of Bain, Mason, Sylos-Labini and others. Yes, in some ways Oliver Hart does go beyond Oliver Williamson (and in other ways much is missing in Oliver H relative to Oliver W), but the fundamental intuition is still Williamson’s. The point is that it is questionable whether formalization is really an engine of discovery of new insights. Which brings us to the “train wreck that is strategy.”

Economists (e.g., George Stigler) have sometimes argued that market for ideas are efficient. Surely, this cannot apply to all markets for ideas, because then the persistence of sociology would cause a too large anomaly. However, one certainly would expect game theory ideas to be prevalent on markets for ideas on strategy because of their apparent relevance. They are not.

In 2004, I participated in a very interesting pre-conference workshop at the Strategic Management Society Conference in St. Juan, Puerto Rico. The subject was the use of game theory in strategy research and among the panelists were Adam Brandenburger. Adam explained — somewhat to my surprise — that there are really little more than a dozen serious, game theory-based strategic management papers around in the major business administration journals. In a later session at the conference itself, Pankaj Ghemawat mentioned a similar number.

It apparently turns out that not only strategy scholars but also real world strategists do not take much of an interest in game theory. The people at FastCompany “assembled a panel of 30 respected game theorists around the world, and we sent them a survey asking, “Can you think of any examples of real, live companies that have consciously applied game-theoretical concepts to a real business problem?” The response was . . . a deafening chorus of head scratching.”

Entry filed under: - Foss -, Strategic Management. Tags: .

Formal Economic Theory: Beautiful but Useless? A Fruity Response

10 Comments Add your own

  • 1. Ryall  |  23 May 2006 at 8:55 pm

    Nicolai,

    Glad to see we are largely in agreement. There are a couple of points worth making in response to your thoughtful discussion.

    First, let me clarify my earlier comment. By “foundational” I simply mean the kinds of theoretical assertions one would expect to find in an MBA textbook on strategy. Typically, these adress issues of firm performance under competition (both positive and normative dimensions).

    By “wrong” I refer to recent findings, e.g., that: 1) the RBV has the unfortunate feature, under certain circumstances, of being a “self-confirming” theory (i.e., a practitioner who follows its key admonitions may persistently destroy firm value, all the while remaining oblivious that his or her actions are suboptimal), 2) resource inimitability is neither necessary nor sufficient for competitive advantage, 3) causal ambiguity is not increasing in the complexity of the causal system in question but may actually be reduced by it. All of these insights are a result of formal analysis picking up on subtleties missed by those who employed natural language to build what now passes for conventional wisdom in strategy.

    I agree with Adam and Pankaj that the present number of formal papers in strategy (game theoretic or otherwise) is low. My interpretation of this is that the formal tools necessary to adress issues of interest to the strategy audience were only recently developed (1990s). For example, many in strategy argued — rightly, in my opinion — that the game theory of the 70s and 80s was far to simplistic to capture the essence of key issues in strategy. However, the 90’s saw an explosion of very general, sophisticated methods that have already proven helpful in refining our thinking about some important strategic issues. Here, I have in mind: game theoretic learning, behavioral economics, graph theoretic applications, agent-based simulation, evolutionary economics, causal inference under uncertainty, and so on. Unfortunately, increased relevance comes at the cost of increased mathematical complexity.

    BTW, I should point out that the volume of formal applications in strategy is increasing. Olin now has an annual conference explicitly devoted to this area and both MS and AMR are coming out with special issues devoted to this line of inquiry.

    I am not qualified to comment on the “real economic substance” that game theory has added to new growth theory or IO.

    Finally, on a minor note, the FastCompany article was, apparently, dishonest. According to colleagues I know who actaully participated in the survey, multiple real-world examples were given and, subsequently, ignored. Be that as it may, one needn’t look too far to see not only that practitioners have an interest in game theory but, moreover, are willing to pay for it. Most MBA programs include game theory in their curricula; these classes tend to be popular; and, most senior game theorists at business schools (Adam and Pankaj being two examples) have thriving consulting practices. In addition, one should also count game theoretic applications outside of game theory proper — for example, it would be hard to get through corporate finance or marketing without running into ideas driven by formal game theoretic reasoning.

  • 2. brayden  |  23 May 2006 at 9:47 pm

    Economists (e.g., George Stigler) have sometimes argued that market for ideas are efficient. Surely, this cannot apply to all markets for ideas, because then the persistence of sociology would cause a too large anomaly.

    And until now I have avoided writing economics-bashing posts….

  • 3. Nicolai Foss  |  24 May 2006 at 12:33 am

    Brayden, I knew you would see it ;-)

    Ryall, Thanks for your detailed response with which I largely agree (didn’t know about the Fastcompany thing). A few comments:
    1. I suppose “resource inimitability” was never a condition for CA in the first place, but only for the sustainability of CA.
    2. Could you give a reference on point 1 (i.e., that the RBV may become self-confirming? Is 3) the Jan Rivkin stuff?

  • 4. Bo Nielsen  |  24 May 2006 at 11:22 am

    Nicolai,

    I was hosting an interesting seminar with a former oil-exec from Chevron (and Shell) last week and he spoke about game theory and how they would use this in negotiations for their large-scale JVs related to oil-exploration, production and sales. I am currently working on getting more details on how exactly they utilized game theory because I too was asthonished to hear that firms actually do use this theory! Once more information becomes available, I will let you in on the “secret” – either here or in a paper…

  • 5. Bo Nielsen  |  24 May 2006 at 12:51 pm

    Oh – another one came to mind: The auctioning of spectrum for wireless telephone service. In both the US and a number of European countries, spectrum was sold at auction and the companies hired game theorists to help them devise bidding strategies.

    This paper (http://www.ww.uni-magdeburg.de/vwl2/teaching/DownloadablePapers%5Cmilgrom_2000.pdf) deals explicitly with this issue.

  • 6. Ryall  |  24 May 2006 at 6:39 pm

    N:

    1. Good catch, I meant sustainability.

    2. Ryall, M. D., (2003) “Subjective Rationality, Self-Confirming Equilibrium and Corporate Strategy,” Management Sci. 49(7) 936-49.

    :-)

  • 7. simon  |  26 May 2006 at 8:35 pm

    Great thread!

    I must start by saying that the strategy theorists have often strayed from recognizing that phenomena must be broadly explained. There is a tendency to develop “theories” that explain specific market leaders, specific industry situations, specific action firms take, etc. RBV explains certain situations quite well while leaving us with little to no insight into others … likewise Game theory offers us with understanding of certain dynamics but adds little to other situations … P&H’s core competence rule changing ideas offers insight into some situations and leaves us out in the cold for why 3rd tier players survive … SCP is also a great theory that offers us little insight today as the world move more quickly … Sutton’s extension to SCP in the IO space are material but have not found broad following … We can add resource dependency theory (which a certain Harvard prof has turned into a lot of cash) …

    We often forget that OT is a large collection of theories. Van de Van’s position of contingency should be taken more seriously by strategy scholars. OT scholars need to spend more time thinking how to develop a theory that more effectively builds upon the contingency logic and specifies more formally context.

    As someone who is academically trained and actively consulting, I find theory critical to problem framing. The trick is to realize all theory ends up being is a framing tool to address a particular problem.

  • 8. Michael Phillips  |  6 February 2008 at 7:38 pm

    Open Options Corporation has completed over 300 projects the last 12 years using an area of Game Theory – Ordinal Non-Cooperative Game Theory – as the main part of our process. We work with companies like Chevron, IBM, Ford, Microsoft, Medtronic, British Gas, Cat and Boeing, for example, and help these firms address with great success business issues that are multi player and extremely complex. Got a great article on how we helped IBM with their Linux strategy if you want to read. Warm regards, Michael

  • 9. michael webster  |  10 February 2008 at 3:44 pm

    Michael Phillips:

    If you are only using ordinal preferences, how do you model risk?

  • […] o menos en línea con Koppl estaría la postura que presenta aquí Nicolai Foss de Organizations & Markets: I think that formalization is definitely an important […]

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