17 May 2012 What can game theory teach us about Financial Supply Chain Management?
Do you ever wonder why it is that businesses don’t co-operate? Each business operates in isolation making decisions that appear to give themselves the best advantage. But it’s rare that they do get to an optimal position and they are not likely to unless they change the rules of the game.
There are two prisoners suspected of conspiring together to commit a crime. There is little actual evidence to convict either and the police are relying on a confession by either or both of them. They are separated and each is offered an identical deal. The deal is that if a suspect confesses, they get 5 years instead of the mandatory 10 years if they are convicted. What should they do?
This is an example of a game and when analyzed using game theory, (not to be confused with gamification by the way), it turns out that each party is most likely to betray each other and spend 5 years in jail rather than remain silent and enjoy the best possible outcome, freedom. It’s counter intuitive in some ways but consider the prisoners’ dilemma. Whatever the other prisoner does, each can improve their likely outcome by confessing. The most likely outcome of this “game” is that each rats on the other.
The prisoners’ dilemma is a very powerful model that illustrates why, depending on the rules of the game, outcomes are not always optimal and there are many close analogies in the real world. Take for example a treasury manager’s behavior in a commercial business. In order to minimize the cost of working capital, it makes sense to pay suppliers as late as possible. Cash rich companies can get a return of about 1% on cash. On the other side of the supply chain fence sits the supplier. The cost to them of working capital – funding the time lag imposed by the customer – is in the region of 20%.
There’s a useful, if somewhat simplistic, way of looking at this. The cost of doing business is 19%. That’s the difference between the cost of working capital of the buyer and supplier. That’s the amount of money leaking from the supply chain. It is the cost of taking a siloed, blinkered approach to financial supply chain management. And it’s an inevitable cost. Why? Because the rules of the game say that, like the prisoners, no collaboration is allowed.
But there’s a better approach. In the real world, the banks aren’t the police. They don’t make the rules. Business makes the rules. If the buyer used their cash reserves to support the suppliers’ working capital requirement, the 19% can stay with the supply chain, distributed appropriately between the buyer and supplier. Sound unthinkable? Impractical? Well it isn’t and what’s more, everybody is better off. Except of course, the banks.