THE CUTTING EDGE : Nobel Puts Spotlight on Game Theory : Economics: The area of study is expected to play a big role in the FCC’s upcoming radio wave auction.

First MCI and Nextel said they were hitching up while Sprint was reportedly talking to Nynex and Bell Atlantic. Now word is out that Sprint wants to join with Tele-Communications Inc., the cable giant, while Nynex and Bell Atlantic would hitch up with MCI.

What are they doing, playing games?

Yes, and it isn’t musical chairs.

The peculiar mating dance is a preparation for the Federal Communications Commission’s December auction of billions of dollars worth of radio wave licenses for new communications services.

It is also the highest profile demonstration yet of an increasingly visible branch of economics called game theory. Game theorists from leading universities helped design the rules of the auction, and nearly all the prospective bidders have hired game theorists to help them play the game.

Just last week, three scholars shared a Nobel Prize for their contribution to the theory, which expands upon classical economics by examining how economic players influence one another’s decisions. Game theorists are now using their complex mathematical equations to help guide decision-making in fields ranging from Treasury bill auctions to negotiation strategies.

“It’s been exploding in the last couple of years,” says Barry Nalebuff, professor at the Yale School of Management. “It’s an incredibly powerful tool.”

Like so much of modern science, game theory was born of the often-sinister calculations of the Cold War. John von Neumann, the mathematics genius and computer pioneer who helped invent game theory while working at Rand Corp. in the early 1950s, advised both Presidents Harry S. Truman and Dwight D. Eisenhower to drop the atomic bomb on Russia before the enemy made the first move.

John Harsanyi, a UC Berkeley mathematician who was one of the Nobel Prize winners, did his most crucial work in the 1960s, helping advise the federal government on disarmament talks. Harsanyi developed models to deal with game theory’s biggest weakness--the assumption that all players have access to the same information--and that has made it possible to apply the theory to broader situations.

“While Russia knows a lot about its own army, it doesn’t know much about the other side,” Harsanyi says. “It’s the same in business.”

But it wasn’t until business schools began teaching game theory in the mid-1980s that it began to be applied to the machinations of corporations.

Game theory tries to explain behavior that classical economists consider irrational, such as predatory pricing. A classical economist would argue, for example, that it doesn’t make sense for a national retailer to drive a local competitor out of business if he could make more money by keeping his prices up and sharing the market with the new entrant.

Yet it happens, and game theory explains why with a concept called “signaling.”

“By taking a Rambo strategy of fighting to the bitter end, they get a reputation for being tough,” says Paul Milgrom, economics professor at Stanford University. That deters competitors from challenging the chain in other markets.

Such concepts have been widely adopted by the Department of Justice and were included in the department’s new merger guidelines released in 1992, says Preston McAfee, professor of economics at the University of Texas.

For companies, game theory has proven especially useful in takeover situations.

Before moving to acquire Medco, the mail order distributor of low-priced generic drugs, drug maker Merck hired a game theorist to study the impact of health reform on its drug prices both with and without Medco. Yale’s Nalebuff advised General Reinsurance of Stamford, Conn., on a bid for Cologne Re-insurance of Germany.

General Reinsurance was worried that it was being used to extract a higher price from a rival bidder, General Electric. Nalebuff advised his client to use its clout as a competitive bidder to change the rules. The company refused to participate in the bidding unless there was only a single round of bids.

Then he suggested unconditional bids that forced a quick response and gave General Electric little time to come up with counter offers. The rules gave an equal chance to the smaller bidder, and General Reinsurance won the contest in a quick, one-week decision.

Game theorists can come up with solutions not suggested by conventional analysis. A satellite manufacturer recently asked a game theorist for advice on dealing with price wars in the business. Customers were inviting representatives from the two competing U.S. satellite makers to sit in a room and bid against each other for each new order. Selling prices invariably fell close to cost. The consultant’s advice? Charge the customer for participating in the auction. If the satellite companies didn’t participate and no auction took place, he noted, the customer would lose by having to pay a far higher price.

Where game theory is weakest is in dealing with complex issues. Increasingly, that is the case in politics, where “rational choice” proponents from economic and math fields are joining political science departments to try to analyze complex political systems. Critics say the analysis must be so simplified to use game theory that it offers little insight.

“It works best in a system where you have reasonably predictable outcomes,” says Boris Rosovsky, a USC mathematician who previously taught at the University of Moscow. “The pursuit of a jet fighter by another jet can be formulated in game theory.”

Another such area is in auctions that have well-defined rules and a limited number of players--such as the FCC radio wave auctions. Last fall, when the FCC announced auction rules, it made frequent reference to the work of game theorists.

Telephone companies, who have an enormous stake in the outcome, didn’t know what to make of the theories. So they rushed out to hire the academics as consultants.

The FCC then turned to UC San Diego economist John McMillan to sort through the responses and come up with the best auction formula.

McMillan suggested an approach proposed by Milgrom in which hundreds of licenses would be auctioned simultaneously. With each player able to see the other bids, there was less danger of underbidding by companies afraid of paying too much. By not publicizing the names behind the bids, the FCC made collusion difficult.

The auction format, however, made it possible for bidders to see at once what combination of properties they are likely to win. This encourages the formation of alliances. Game theory consultants are now busily advising telephone companies on partnerships.

Bell Atlantic’s interests, for example, are to join with the player who has the most to gain from the licenses and therefore is likely to bid the highest price--thus turning a competitor into an ally. MCI is the best bet, analysts say.

What are the game theorists’ predictions for alliances? They believe in brinkmanship, so count on deals being made and broken right up to Oct. 28, when companies must declare their partners. Then look for a new round of negotiation as the spoils are divided.