Game+Theory+in+Business+-+Contingency+Theory


 * Contingency Theory and Business Strategy **

According to Wikipedia (accessed 29/11/14), "Contingency theory is a class of behavioural theory that claims that there is no best way to organize a corporation, to lead a company, or to make decisions. Instead, the optimal course of action is contingent (dependent) upon the internal and external situation. A contingent leader effectively applies their own style of leadership to the right situation." Business strategy basically means approaches or methods employed by an organisation in reaching its organisational objectives whether short term or long term.

Every business operates in an environment consisting of many other players which may be in competition with it or be in a different game entirely. Some entities are hindrances to the company’s success while some are enablers. Therefore every strategy made by the company must consider key factors in the environment some being present factors seen while some are unforeseen. In reflecting on business strategies one would soon realise that every business strategy must be contingency-based (Ginsberg and Venkatraman 1985).


 * Game Theory and Contingencies in Business Strategy Formulation **

Because business strategy formulation involves contingencies, it is by nature a form of game theory. Every organisation must select a strategy (of many) in light of varying organisational factors which are based on probabilities. The strategy selected will result in either profit or loss or winning or losing.

For example: trading financial instruments in the stock exchange. A trader has the option of buying either stock A or stock B or both and both cost $20 each. His strategy has always been to buy low and sell the stock when the value appreciates. In reviewing information regarding both companies, he gathers that if the price of A rises he’ll make a gain of 50% and if B rises a gain of 80% however, if both fall A would only fall by 10% but B could fall by as high as 90%. However the determining factor for changes in the prices of these stocks is the profitability of new drugs being developed by both companies. Success means a rise in stock while failure means a drop in the stock prices. There is little information about both drug projects. This is typical example of how game theory features in strategy formulation with varying contingencies. In this case we would have a matrix as such:

 $10 $16 || (80%x20)-(10%x20)=$14  $16 ($2) ||  $10 ($18) || -(90%x20)-(10%x20)=($20)  ($18) ($2) ||
 * || A Succeeds || A Fails ||
 * B succeeds || (50%x20)+(80%x20)=$26
 * <span style="font-family: Arial,Helvetica,sans-serif;">B fails || <span style="font-family: Arial,Helvetica,sans-serif;">(50%x20)-(90%x20)=($8)

<span style="font-family: Arial,Helvetica,sans-serif;">Without knowledge of probability of both contingencies, one would clearly choose to buy only stock A. However if probabilities were introduced with more information about the projects, say A has only a 10% chance of being successful but B has a 95% chance of being successful, the table would look as such:

<span style="font-family: Arial,Helvetica,sans-serif;"> $1 $15.2 || <span style="font-family: Arial,Helvetica,sans-serif;">(95%x80%x20)-(90%x10%x20)=$13.4 <span style="font-family: Arial,Helvetica,sans-serif;"> $15.2 $1.8 || <span style="font-family: Arial,Helvetica,sans-serif;"> $1 ($0.9) || <span style="font-family: Arial,Helvetica,sans-serif;">-(5%x90%x20)-(90%x10%x20)=($2.7) <span style="font-family: Arial,Helvetica,sans-serif;"> ($0.9) ($1.8) ||
 * || <span style="font-family: Arial,Helvetica,sans-serif;">A Succeeds (10%) || <span style="font-family: Arial,Helvetica,sans-serif;">A Fails (90%) ||
 * <span style="font-family: Arial,Helvetica,sans-serif;">B succeeds (95%) || <span style="font-family: Arial,Helvetica,sans-serif;">(10%x50%x20)+(95%x80%x20)=$16.2
 * <span style="font-family: Arial,Helvetica,sans-serif;">B fails (5%) || <span style="font-family: Arial,Helvetica,sans-serif;">(10%x50%x20)-(5%x90%x20)=$0.1

<span style="font-family: Arial,Helvetica,sans-serif;">With knowledge of these contingencies the trader can decide on which course of action to use. Looking at the outcomes, the trader would now consider buying both stocks with the worst possible outcome of $2.7 loss.