An Example of Game Theory in Risk Management

This analysis was co-authored with Norman Marks, CPA, CRMA and originally posted on his blog.


Many liked the post on Risk and Game Theory with Ruth Fisher (my co-author on the piece). We were asked for more, especially an example or two.

As with the last post, I will set the stage and then Ruth will share how game theory can be used.

This is more an article than a blog post, as the explanation of how to solve the problem takes a while. It is also, at times, complex. If you want, you can skip some of the technical stuff (equations and so on).

The main thing, for me, is to understand that the optimal action to address the identified risk has to consider not only the perspective of the ‘owner’ of the risk (Management) but also the perspectives of the other two parties (the Employees and Competitors). Game theory factors how the other parties will react into the process of making the decision of how to respond to the risk.

Your comments and reactions are welcome.

One of the risks identified by many organizations as significant and included in the risk disclosures required in corporate filings, such as the annual and quarterly filings with the U.S. Securities and Exchange Commission, is the loss of key personnel.

Here is an extract from IBM’s 2016 Annual Report on Form 10-K:

The Company Depends on Skilled Personnel and could be impacted by the loss of Critical Skills: Much of the future success of the company depends on the continued service, availability and integrity of skilled personnel, including technical, marketing and staff resources. Skilled and experienced personnel in the areas where the company competes are in high demand, and competition for their talents is intense. Changing demographics and labor work force trends may result in a loss of or insufficient knowledge and skills. In addition, as global opportunities and industry demand shifts, realignment, training and scaling of skilled resources may not be sufficiently rapid or successful. Further, many of IBM's key personnel receive a total compensation package that includes equity awards. Any new regulations, volatility in the stock market and other factors could diminish the company's use, and the value, of the company's equity awards, putting the company at a competitive disadvantage or forcing the company to use more cash compensation.

Assessing this risk is not simple.

Arguably, the risk is different for different groups of personnel such as:

  • The CEO
  • The direct reports to the CEO
  • Their direct reports
  • Middle management
  • Individuals with critical skills or knowledge, such as those leading innovation and product development
  • Other personnel where the loss would be significant but replacements might be found within a reasonable period

So let’s focus on the risk of losing people in the critical skills or knowledge category.

IBM’s discussion focuses on losses due to others offering greater compensation. No mention is made of losses due to employee morale problems and so on – so I will focus on compensation.

At first blush, this may seem fairly straightforward. But in real life identifying the risk, assessing its level, and evaluating whether it is acceptable is only a start.

It can be quite complicated, even for what seems a simple risk like the potential to lose people, to figure out what to do about it.

Most risk managers, unfortunately, don’t pay enough attention to the response to risk.

First Game Theory Group Meetup

Group Introductions

Introduction of HDTV Technology

Definition of a Game

Insights into Technology Games and New Technology Adoption

How Do You Change the Environment?

Mapping Out a Game

How to Determine Which Choice Will Prevail


October 22, 2104


Group Introductions

The 7 attendees were seated around a large table. Before the talk began, people introduced themselves and gave a short description of their background. The audience included gamers and software and systems people. Several people commented that they were interested in applying game theory to “negotiations” with co-workers, that is to figure out how to better get things done. Others were interested in applying game theory to gaming.


Introduction of HDTV Technology

I started my talk with a description of the introduction of the HDTV technology into the market in the 1990s. At that time, when digital technology was introduced, TV programs were being broadcast in analog. The government wanted the transition from analog to digital to proceed quickly, because the government planned to use the analog spectrum for emergency services and other government services.

However, users did not actually end up adopting the new technology very quickly at all, because (i) the TVs were expensive, and (ii) there was very little programming available in digital. Before users would adopt the new technology – by purchasing the expensive HDTVs – they wanted there to be plenty of programming available to be able to watch.

Game Theory Basics

What Is Game Theory?

Game theory is a tool that’s used to “map out” particular situations and figure out what is likely to happen under various scenarios.

In some cases game theory is employed by means of modeling situations using mathematical equations. In these cases, the equations can be used either to solve for optimal solutions and/or to generate simulations to see how the situation plays out under different scenarios.

However, game theory can also be employed using less rigorous methods. Most situations can be mapped out visually and textually, and then one can use those mappings to better understand situations and draw conclusions.


When Can Game Theory Be Used?

Game theory can be used in situations in which an entity’s payoff (profits, well-being, etc.) is dependent upon actions taken by other entities.

As the world has become globalized and markets have accordingly become more interconnected and complex, game theory has become increasingly applicable to more and more situations. In particular, more situations have become characterized by global ecosystems, in which many players from different countries are involved to different extents and at different levels.

Overview of Technology System Dynamics

This is a presentation I’m preparing for “Tech Startup Conference: Artificial Intelligence” being held on September 26, 2017.

1. Issues Covered

  • Adoption of New Technology Systems: What does it take for new technologies to become successfully adopted in the marketplace? Why do some technologies become adopted while others do not?
  • Value Creation: How do the components of the system combine to create value for the different players? Can the environment be changed so that the system will create more value?
  • Value Extraction: How much value does each player extract? In particular, are players extracting as much value from the system as they can?

Theory vs. Reality

What’s the difference between theory and reality?

In theory, nothing…

Unfortunately, in the real world, what start out as great ideas in theory often end up being implemented in ways that lead to not-so-great outcomes in practice.

I remember sitting in a grad school class, The Economics of Regulation, when I was introduced to this truism. We would consider a situation, say, manufacturers who pollute the air in the process of making their outputs. We would determine the first-best solution for the situation. Then we would consider “next-best” alternatives. So often, after all the politicking is done and the details are finally settled upon, the regulations that end up being legislated bear no resemblance to any solution on the “best” list. In fact, many solutions end up exacerbating the initial problem it was supposed to fix! It was then that I realized the often stark differences between theory and reality.

Why Don’t Projects Go As Planned?

Business projects, government programs, and social activities. We make plans and projections for the activities we are going to undertake. Yet, when we actually implement the programs, all too often, the results don’t turn out as well as we had planned. Why not?

I had a client, for example, that employed a dedicated staff to provide IT support services to the company’s employees. However, the company discovered that employees were by-passing the IT staff and, instead, using knowledgeable co-workers to help with their IT problems. The time the helpful co-workers were spending on IT issues was eating into the time the helpers should have been spending on their company-assigned tasks. In this case, the company implemented a program — the provision of dedicated IT services — but employees responded to the program in an unexpected way: rather than using the dedicated staff to solve their problems, employees were turning to other coworkers. The unexpected responses of employees ended up derailing the effectiveness of the company's program for providing dedicated IT service.

Business projects, government programs, and social activities are all undertaken in social environments. They involve people. People act, react, and respond to one another’s actions and to changes in the environment. And people can act, react, and respond in “unexpected” ways. There’s a good chance that if your program did not play out as planned, it’s because you didn’t anticipate actions, reactions, or responses that people would take within the new environment.

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