18.19 : Strategic Moves: Side Payments

Side payments are a strategic move in sequential games where one player offers a benefit to another to encourage cooperation. This tactic adjusts the payoffs for both players, making it more appealing for the opponent to choose an action that is beneficial for both players. It helps shift the dynamics of the game, leading to outcomes that are more favorable than those achieved through competition.

Consider two telecommunications companies, TelNet and SignalMax, that are planning to expand into a new region. TelNet has two options: compete aggressively by lowering prices or propose a partnership. TelNet chose the partnership strategy and offered SignalMax a side payment of $300. Without this payment, SignalMax would receive a payoff of $500 from the partnership, while TelNet would earn $400. With the side payment, however, SignalMax's total payoff increases to $800, making the partnership more attractive than the competition.

This side payment ensures that SignalMax is incentivized to cooperate, leading to a more stable and profitable outcome. If TelNet had instead chosen aggressive competition, it might have earned only $50 due to high marketing expenses, while SignalMax would have earned $350. TelNet strategically reshapes the game's payoffs by offering a side payment, making cooperation the most advantageous option for both parties.

Side payments are effective because they allow one player to influence the game's structure by sharing some of its own gains from cooperative behavior. This encourages an outcome that maximizes profits and stability for all. By realigning the incentives facing other players' decisions, one player can create a Nash equilibrium, or a stable state where neither player benefits from changing their decision. This approach minimizes risks and avoids the lower payoffs associated with direct competition, ensuring a mutually beneficial outcome.