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Incentivizing businesses to achieve climate goals with game theory

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Introduction

Hello everyone,

My name is Joshua Lorincz and this is my Catalyst conference project. I chose this project because I am interested in the positive impacts that business can have on the world. You can’t read the news these days without hearing about the negative impacts that industries and industrialization are having on our environment. What’s holding businesses back from working towards a cleaner climate and eliminating pollution? I’ve decided to apply game theory to this crisis to examine what businesses and the government should do as we progress towards a sustainable future.


My Project

Regardless of one’s opinion of the power that money should have in society, it is unequivocally true that money is a driving force in most industries and the way that we direct our resources. To date, there have been billions of dollars spent lobbying against climate change legislation, according to Yale University.

People need to stop financing denial of climate change.

Al Gore

The monetary incentivization for politicians to not support climate deals outweighs that of supporting climate deals by 10:1. It would be easy to say that we should fix the climate problem by banning climate lobbyists, and this may be a valid approach. However, it does not address the root of the problem; businesses believe that it does not make financial sense for them to move towards sustainable solutions. Using theories of game theory, we will look at whether or not this indeed makes sense, as well as, what makes sense for a government to do in this same situation?

To begin understanding the situations we must create a matrix representing our problem.

This matrix compares three general strategies for the government and two general strategies for business. The letters inside the matrix represent possible payoffs that either the government or companies could receive. The first letter represents the payoff to the government while the second number represents the payoff to business. A notable outcome that hurts both players is the one with payoffs b, v. In this situation, the climate worsens, and the government is in conflict with businesses. We can define the payoffs using the logic below:

Inserting these values we are given the following matrix:

This matrix is what we will use to represent the climate change problem, as even though it overlooks many details, I feel that it is a good representation of the general situation involving climate change, the government, and business. The first step in understanding the situation is using movement diagrams to understand both players optimal strategies.

Movement diagrams work by finding each player’s “favorite” strategy in either the particular row for the column player or particular column for the row payer. If an outcome contains a “favorite” strategy for both players, then that outcome will be a Nash equilibrium. Using the movement diagram we can see that the optimal strategy for the government is to create climate laws, while the optimal strategy for business is to reduce pollution. This is the Nash equilibrium. Next, we will look at which strategies benefit businesses and government the most as a whole, by finding the Pareto optimal solutions.

The red line represents the Pareto optimal solutions

In this diagram, the x-axis represents payoffs to the government, and the y-axis represents payoffs to businesses. This diagram shows that the Pareto optimal solutions are businesses reducing pollution while the government either protects businesses from climate laws or creates climate laws. Any combination of these two solutions is also Pareto optimal. Pareto optimality describes what solutions are the best for all parties involved. As the points that are the farthest to the right and farthest vertically from the origin will provide players the best payoffs, it is logical that these payoffs are the most socially optimal.

Socially optimal solutions are better for everyone

What if we view this situation as a sequential game, where first the government chooses what to do and then businesses choose what to do? Unlike previous analysis, this method assumes that companies know what the government has done before they choose their strategy. This should more effectively simulate real life than the matrix above. We can then use backward induction to find each player’s optimal strategy. Backward induction works by starting at the bottom of the diagram and working up. So in this situation, we first see which outcome businesses would choose for all possible choices that the government could make. Hence, given the three decisions that companies would make we can find the strategy that the government would choose. This “line” of strategies is the optimal strategy for each player.

As can be seen, the optimal strategy for the government is creating climate laws, while the optimal strategy for business is reducing pollution. This is the same result that we found using the Nash equilibrium.

Conclusion

As has been shown by the numerous methods of solving this problem using the principles of game theory, the solution for a simplified version of the climate change problem is for the government to create climate change laws and businesses to reduce pollution. This will give the government an approximate quantified payoff of 100, while it gives businesses an approximate quantified payoff of 10. A logical reason for this is that regardless of what the government does it makes sense for companies to reduce pollution as they will both avoid consumer backlash and live in a better world. Therefore, the government must choose how to move forward. In the long term, creating climate laws is the most beneficial, so the government will choose this as their strategy. This outcome is also Pareto optimal showing its social benefits.

The implications of this are quite beneficial for the world as it shows that it is a dominant strategy for businesses to reduce pollution. Given this one can think of two possible reasons that companies today do not attempt to reduce their pollution. The first is a lack of awareness that a transition towards more sustainable solutions is available and advantageous. The second is that specific climate regulations will directly hurt business profits or industry position. For instance, an oil company has no reason to support climate regulations.

Below is an interactive Padlet, feel free to leave any ideas or suggestions pertaining to the statement at the top.

Made with Padlet

So how do we fix this? Well, we need to give an increased opportunity, and possibly a market incentive, to companies that are willing to transition towards decreasing pollution and renewable energy solutions. Funds for such a program could be created through government tariffs on pollution production. In this way, a country could create a sustainable solution to a problem of sustainability, and humans as a group could move towards a future not threatened by climate change.

What can you do?

As it is nearly impossible to influence a multi-national corporation, the most important thing that you can do individually is spread the knowledge that it is advantageous for everyone to reduce pollution and their negative impact on the environment. This may lead to social pressures making it even more optimal for bussinesses to take action on these issues and reduce their environmental impact.

References

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