The saying “life is just a game” is not true, but the survival of some companies may depend on acting as if it is. Bear that in mind as Northwest Airlines’ bankruptcy proceedings and union negotiations play out.
The airline business is an oligopoly — an economic sector with very few competitors — and in an oligopoly, the adroit use of “game theory” to make decisions can help one firm survive while others go under.
For decades, only mathematicians, nuclear strategists and economists paid much attention to game theory. It took the 2001 film “A Beautiful Mind,” about John Nash, the brilliant mathematician who struggled with schizophrenia but eventually won a Nobel Prize, to change all that.
Nash, together with co-laureates John Harsanyi and Reinhard Selten, got the 1994 economics prize for applying game theory to varied areas of economics. Game theory analyzes decision-making when the best alternative in a situation depends on what someone else chooses to do.
The field is young. John von Neumann, one of the most brilliant mathematicians of the 20th century, got things started with a 1928 article written in German. It gained greater recognition after 1944 when von Neumann, together with economist Oskar Morgenstein, wrote a book called “Theory of Games and Economic Behavior.”
One of the simplest games, the “prisoners’ dilemma” is the best place to start: Someone robs a bank. As in the movie “Casablanca,” the cops “round up the usual suspects,” including Bugsy and Moe. These two did, in fact, pull the heist, but left little evidence. Nevertheless, police give them separate, pre-Miranda interrogations.
“Bugsy,” they tell the first, “We got a witness, we know you did it. But if you want to do yourself a favor, you can save us a lot of time and money by turning state’s evidence. Testify against Moe and we’ll let you off with a year. He’ll be up the river for 10 years so you won’t have to worry about anything. Don’t think about being a tough guy because we’ll convict you eventually anyway. Then you’ll do 10 years of hard time. Oh, yeah, make up your mind quick, because if Moe rats you out, he’ll be free as a bird in a year and you will rot away for 10. And if you both confess, you will each get five. You better sing before he does.”
At the same time, the cops say the same thing to Moe in another room. They know that the evidence is weak and that if they go to trial, both may be found not guilty or get, at most, a few years.
Thinking rationally, Bugsy and Moe both know this. If both are stand-up guys, neither will get more than a few years. They might get off entirely.
But in the back of their minds, each must wonder, “What if he sells me out?” If they cannot communicate with each other and disregard eventual reprisals, the best strategy for each is to confess and testify against the other. Better to take one year in the big house than a high probability of 10 years. Each confesses and each gets five years. (The outcome where both confess is called a “Nash equilibrium,” after the Nobelist who explored it.)
That game, with only two players, no possible cooperation between Bugsy and Moe and no replays, is simplistic. Northwest, American, United and Delta airlines play much more complicated games, of which bankruptcy is only one.
Filing for bankruptcy allows an airline to break contractual commitments and dump costs. It also increases uncertainty and increases other costs. As long as no competitor will file, not filing yourself may be the best strategy. But if, by holding off, you allow other firms to get into bankruptcy before you, they will gain a competitive edge that you will have to rush to close. Moreover, each time a major airline files, the possible payoffs for each of the others changes.
Bankruptcy is not the only game airlines play. In decisions to raise or lower fares, drop or add routes, settle with unions or force strikes, buy planes or sell them, identifying the best choice depends at least partially on what the competing players do.
Northwest makes decisions based on a judgment of what United and American, et al., are likely to do and how they are likely to respond to each alternative that Northwest might choose. But at the same time, United makes decisions based on its estimates of what Northwest and American will do. These calculations are not only repeated with each competitor, but depend on the expectations of how the several different competitors will respond to each others’ moves.
The number of possible permutations grows exponentially. Firms hire expensive Ph.D. consultants and buy more powerful computers to analyze the problems. In the meantime, most of us get to watch the games and hope that our tickets and frequent-flier miles are still good when we need them. But for airline employees, pension recipients and other stakeholders, the choices the players make can have life-changing implications.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.