More and more lawyers are using the science of game theory to help achieve better contractual and financial results in negotiations for their clients. But what is game theory and how can it be used to transform legal and business outcomes?
What is game theory?
Back in the 1700s Scottish economist, Adam Smith, proposed the idea that people’s behaviour responds to incentives.
Game theory is a mathematical and economic theory that builds on Smith’s work. Remember Russell Crowe as John Nash in ‘A Beautiful Mind‘? Nash was an American mathematician who made important contributions to it in the 20th century.
Game theory brings a mathematical approach to the analysis of decision making. It uses ‘games’ to help analyse situations and predict at a strategic level how humans will interact and make choices.
A very simple example of game theory in action is the ‘cake cutting’ game. Two brothers want a piece of cake. Their mother says that one can cut and the other then gets to choose. We can predict that the brother cutting the cake will more likely than not cut it down the middle so as to maximise his portion.
A more complex example of the balance between completion and co-operation on action is the ‘Prisoner Dilemma‘ scenario. In this game the police arrest two suspects. No matter what the other suspect does, each can improve his own position by confessing. But when both confess, the outcome is worse for both than when both keep silent.
How is it different?
In game theory each party knows his own information, is equipped with a number of different options or strategies and understands the payoffs for each combination of strategies. Incentives are still important in game theory but the improvement on traditional ‘Adam Smith incentives’ is that a party is aware of how his or her strategic decisions and positions will affect the other party(s). Players can apply the tactics and strategy of game theory and modelling to help plan their business relationships and interactions.
Application to contract negotiation
Economists have been using game theory for over 50 years. But how can the cold war economic theory of game theory apply to 21st century contract negotiations?
A commercial contract is simply a way of allocating risk in a relationship between two parties, commonly a supplier and a customer. When a supplier and a customer negotiate a contract they will both seek to draft clauses which minimise their risk if, for example, something goes wrong. The ultimate negotiating plan to to pick the strategy where the maximum advantage of your opponent is minimized.
The tools of game theory and information economics can be applied to legal negotiations. Lawyers can use game theory tactics to help inform their bargaining strategies and decisions, which in turn can help minimise the client’s risk.
Opponent’s aims and motivators
To maximise the benefit of game theory and make accurate forecasts the player will have to learn what the other side wants from the negotiation. Game theory requires the first person to take into account how the second person will behave in making a decision. The trouble is that the second person may be trying to do exactly the same thing!
With this in mind, the better approach in a game theory negotiation is to make the first proposal. While many will be reluctant to do this, making the first move allows the player to establish precedence and frame the negotiation.
There are a number of assumptions associated with game theory including:
- The payoffs are known and fixed.
- All players behave rationally and in their own interest.
- The rules of the game are common knowledge and players consider the competitive responses of their opponents.
One of its potential drawbacks is its reliance on sanitised models that often contain unrealistic assumptions. On the other hand, real life negotiations are complex and it is impossible to know all of the information available to your opponent and to understand all of their strategies.
Other things to remember
As with any form of negotiation, game theory won’t work in isolation. A good negotiator still relies on key factors:
- Prepare, prepare, prepare. Preparation and preparing your strategies and analysis of the other side’s possible positions’s and responses is very important.
- Leave your ego and emotion at the door. A strong negotiator establishes a raport with the the other side and frames themselves as a credible negotiator.
- Law is a small industry and the other side will remember you. This can affect your future dealings so keep it polite and professional.
Even though game theory is not a panacea, if the players prepare their strategies correctly and construct analysis of their opponent’s likely responses the model can help reduce risk and create competitive advantages. However, game theory should always be used as an aid to help clarify thinking and to create strategies to outfox opponents. It is not a substitute for lack of preparation or lack of experience.