Game Theory: Changing the Way You Think About Commodities

Spend Matters welcomes this guest post from Nick Peksa, opportunities director at Mintec.

In 2014, we published an article on chaos theory, and as a continuation of this, I thought it would be interesting to introduce the concept of game theory and how you can use it to support your commodity price decisions. Before we start, I would like to summarize my previous article.

Chaos theory is the study of the behavior of dynamic systems that are highly sensitive to initial conditions. It describes any situation where a seemingly small change can be magnified to produce a much stronger change in outcome.

We find these dynamic systems almost anywhere, including in the commodities market. Time and again we find a strong relationship between seemingly unconnected commodities. Often as we delve deeper into the relationship between the commodities, however, the connection becomes apparent.

Game theory differs in the sense that the outcome of any interaction is not known and probably can’t be accurately predicted. By playing the game and understanding the other players, however, you can gain an advantage. Game theory brings together the concept of competition and cooperation in business.

If you have a situation where two suppliers dominate the market, a duopoly, the players who “work together” will both have a higher probability of success. If they chose to compete against each other, however, neither party will benefit in the long run. A classic example of this destructive behaviour would be a price war.

If soft beverage company 1 aggressively cut its sale price to capture the market share, soft beverage company 2 will follow suit. To finance these efforts, their supply chains will be squeezed on price. At the end of the war, logic dictates that the two competing soft beverage companies will end up with similar market shares, just derived from a smaller pie. The net result is that both beverage companies have successfully eroded their margins and the margins of their suppliers and their respective supply chains. The only winner in this price war would be the consumer, as the cost of the soft drink would decline.

Alternatively, if both parties chose to innovate, their respective margins would stay high and their innovation could create value in the form of new products or services. The net result would be higher profits and potentially a larger pie for everyone to share. While the consumer may not receive any price benefits, they will have new choices of products and services.

So how does this affect the commodity market or raw material prices? Firstly, the game theory prompts you to think about other players in the game. What are their motivations and how might they react in a given situation? Answering these questions may give you a competitive advantage. For example:

  • Farmers: If there is a bad harvest of potatoes and the price goes up, will other farmers plant more potatoes next year? Is it best to plant something else this year?
  • Cooperatives: On negative harvest news, what would happen to the price if we limited supply? Would the buyers panic causing a price increase?
  • Retailers: Can changing the label on the product to advertise specific attributes change the buyer’s perspective? For example, does adding the word “vegan” to rice sell more?
  • Manufacturers: Can a manufacturer use the threat of increasing capacity to prevent new entrants coming to the market for a particular product? Why spend money on investment when a threat is enough?

I understand these are all simple examples, but if you can think ahead and plan, you may be able to gain advantages in the market place. I know I use it myself: I buy my lawn mowers in winter, I book travel on New Year’s day and I collect bargains from eBay on public holidays (auctions ending on Christmas Day at lunch time is my personal favorite).

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