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AI Washing: A game theoretic analysis of deceptive market practices

AI Washing: A Game theoretic analysis of deceptive

market practices

Tanmoy Adhikary

Rananjan Banerjee

Dhriti Dhar

Department of Economics, Indian Institute of Foreign Trade

Microeconomics – II

Supervised by: Dr Oindrila Dey

May 15, 2023

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AI Washing: A game theoretic analysis of deceptive market practices

Abstract

In this paper, we use game theory to analyze the strategic deployment of misleading AI portrayals, a
phenomenon known as AI washing or Machine washing. To the best of our knowledge, there is no paper
yet which has modeled a strategic interaction between firms practicing AI washing and the investors
seeking to invest in those firms; and hence we have tried to develop such a model in this paper. The
analysis reveals how AI washing can distort markets, prevent investors from making fully informed
choices, and impact the incentive to improve true AI capabilities.

Keywords: Game theory, AI Washing, Signaling game, Perfect Bayesian Nash Equilibrium
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AI Washing: A game theoretic analysis of deceptive market practices

Introduction

Artificial intelligence (AI) has become a ubiquitous term, promising advancements across
diverse fields. It has rapidly transformed from a science fiction trope to a revolutionary force
shaping our world. AI offers increased efficiency and accuracy by automating repetitive tasks,
freeing humans for creative endeavors, and tackling complex problems in science, finance, and
more. However, alongside genuine AI development, a concerning trend has emerged: the
misleading portrayal of non-intelligent technologies as AI. This phenomenon, known as ‘AI
washing’ or ‘Machine washing’, involves companies exaggerating or fabricating AI capabilities
to gain a competitive advantage. It is akin to the concept of green washing, which is the practice
of making misleading advertisements regarding the positive impact a firm or its product has on
the environment. Such Deceptive practices including AI washing leads to a breakdown of
confidence between vendors and their consumers, enterprise partners and investors. As per a
very recent report published by Tech.co, two investment firms have been charged a hefty fine by
the US Securities and Exchange Commission for engaging in the practice of AI Washing. An
article from the Economic times (Mar 18, 2024) discusses how SEC Division of Enforcement
director Gurbir Grewal has stated that if any company wishes to use AI in their investment
process, the representations should not be misleading or false.
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AI Washing: A game theoretic analysis of deceptive market practices

Objective

In this paper, we have tried to structure a game theoretic framework where we model an
interaction between firms and their potential investors. By analyzing this strategic interaction,
this paper aims to contribute to a deeper understanding of the economic and societal implications
of AI washing. Our findings can inform stakeholders - firms, investors, and policymakers - about
the potential pitfalls of misleading AI portrayals and the importance of fostering transparency in
the development and deployment of AI technologies.

Methodology

In this context, the interaction between firms and investors resembles the deceptive tactics
employed by companies engaged in greenwashing. To analyze this dynamic, we have adopted
the framework of a classic signaling game. This framework is commonly used to shed light on
greenwashing practices (Eric Tham, 2023). The game presented in this paper is one where the
principal (investor) possesses incomplete information about the action of the agent (firm) . Since
this is a Dynamic Game of Incomplete Information, there can be three types of equilibrium -
Separating, Pooling and Semi-Separating, depending upon the signals provided by the firms.
These signals can be based on the firm's inherent characteristics. Our research has focused on
identifying distinct sets of equilibrium by examining how different threshold levels of specific
variables might influence the interaction. Subsequently, we have interpreted these results by
drawing upon economic principles to provide a more nuanced understanding of the underlying
dynamics at play.
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AI Washing: A game theoretic analysis of deceptive market practices

Premise and Assumptions

● There are two players in the game : Firms and Investors

● The firms can be of two types – the Good type, and the Bad type.
⮚ The Good type, which we shall denote by Ɵ1, indicates those kind of firms who
are truthful regarding the proportion of AI they use in their technology.
⮚ The Bad Type Ɵ2, which we denote as the kind of firms who fabricate or
exaggerate their use of AI and end up deceiving investors and consumers.
● The type of the firm is determined by Nature, and is private information to the Firms.
● The Investor is homogenous, i.e., of a single type.
● The firms send Signals to attract the attention of the investors. Signals can be interpreted
as advertisements or marketing strategies which entails a certain cost.
Further elaborating, Signals can be of two types :
i)High Signals, which indicate high usage of AI and
ii)Low Signals, which indicate less usage of AI, and more of human labor force.

● Depending upon the two types of Signals, there may be four consequent cases:
⮚ High Signal from a Good Firm: Refers to the situation where the firm truthfully
and correctly signals their usage of AI.
⮚ High Signal from a Bad Firm: Refers to the situation where a firm exaggerates
their usage of AI.
⮚ Low Signal from a Good Firm: Refers to the situation where the firm does not
reveal what kind of technology they are employing, even if they use AI to a large
extent. Since in reality there can be situations where high usage of AI can bear a
negative connotation to the investors especially in sectors where high usage of AI
is not encourage or when the firm is not will to give out its flagship technologies.
⮚ Low Signal from a Bad Firm: Refers to the situation where the firm remains silent
about its actual usage of AI and HI.
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AI Washing: A game theoretic analysis of deceptive market practices

● In this game, The Firm makes the first move by Signaling what kind of technology they
use, and then the investors make their move of whether to Invest or Exit(actions). Hence,
this is a game of Sequential move or a Dynamic Game.
● The Investor is unaware of the actual type of the firm as it is private information to the
firm only; hence this is a Dynamic Game of Incomplete Information.
● The Investor, or the Principal in this problem, is assumed to be risk-neutral.
● The product/service that the firms are selling are homogeneous. It is also assumed that
the same product can be produced in both ways, through high as well as low usage of AI.
● Investment is a function of usage of AI i.e. showing that the firm uses AI to provide its
services, attracts more investments.

There is growing empirical evidence that suggests a positive relationship between investment in
AI and firm value. Several studies have examined this relationship and found that firms that
invest more in AI tend to experience higher valuations and financial performance.

One study published in the Harvard Business Review analyzed data from over 1,500
publicly traded companies and found that firms with above-average AI capability had a
market value that was on average 6% higher than their industry peers. The researchers
attributed this premium to the competitive advantages and productivity gains that AI can
provide to businesses.

Another study by the MIT Sloan Management Review and Boston Consulting Group
surveyed over 3,000 executives and found that firms that had successfully deployed AI at
scale saw a 5% increase in their cash flow as a result. This increased cash flow was then
reflected in higher firm valuations.

Additionally, a report by the McKinsey Global Institute estimated that the adoption of AI
could potentially contribute up to $13 trillion to the global economy by 2030. This
suggests that firms that invest in and effectively leverage AI are likely to see significant
financial benefits, which would be reflected in their market valuations.

Overall, the available evidence indicates that there is a positive relationship between a
firm's investment in AI and its market value. Companies that are able to successfully
integrate AI into their operations and business models tend to experience higher
profitability, productivity, and competitive advantages, all of which contribute to
increased firm value which inturn helps to bring in more investments.
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AI Washing: A game theoretic analysis of deceptive market practices

Analysis

We begin constructing the model by explaining the payoffs of the players in the game.

i. Firm’s payoff is given by:

𝐹𝑖 = 𝑢 − 𝑆(𝑖) − 𝑘𝑃 − 𝐿

Where,

o u = utility gained by the firm from getting an investment

o Si = the cost of signaling (i = High, Low)
o P = additional cost to implement actual Artificial Intelligence
o k = an arbitrary constant lying between 0 and 1
o L = reputation cost, regulatory cost etc.
o kP = cost incurred by the firms who do not have to incur the full cost of implementing
AI

ii. Investor’s payoffs is given by:

π = θ𝑅 − 𝐶 − λ( θ𝑅) − β(θ𝑅)

Where,

o R = gross return from the investment made

o C = the cost of investment, or, the invested amount
o λ( θ𝑅) = Potential loss that the investor may have to bear by investing in the Bad type
firm
o β(θ𝑅) = disutility from not investing in the Good type firm.
o θ ϵ [0, 1) for the Bad type firm ; θ = 1 for the Good type firm.

Technical Assumptions : kp>l, S(b)>S(g).

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AI Washing: A game theoretic analysis of deceptive market practices

Here, we explain the Game tree and the payoffs:

If the G type firm signals High and it leads the investor to invest in that firm, then
payoff for that firm will be the utility derived from the investment (which is same for
both the firms) minus the signaling cost incurred and the cost of using AI to achieve the
anticipated outcome (or service). The investor’s payoff from it would be the invested
amount deducted from the gross return from the investment. If the firm exits here, then
the investor’s payoff will be the amount that is not invested ( as now it can be invested
elsewhere) minus the psychological burden of not investing in a good firm.

If good firm plays high, and the investor invests, then the firm's payoff will be the same
kind of with additional regulatory costs(there is real life evidence supporting this kind of
regulatory fine attached in reference) for not disclosing its functionality. The firm’s
payoff will be similar to the previous one but here it expects to get lower return from the
investment.

If the Bad type firm exaggerates and gives high type of signal and the investor invests
then, firm’s payoff will be the utility derived deducted from his signaling cost and cost of
using AI ( though the cost is lower than that of good firm, since AI usage is low and we
assume using Human Intelligence or HI is cheaper due to cheap labor cost); while for the
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AI Washing: A game theoretic analysis of deceptive market practices

firm’s payoff there will be an additional cost of potential risk for investing in a bad firm.
If the bad firm is truthful or remains silent about its functionality, its payoff will be
similar, kind of along with the potential loss. Other payoffs in the game tree can be
explained similarly.
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AI Washing: A game theoretic analysis of deceptive market practices

In a basic signaling type of game, there can be two types of equilibrium, (i) Pooling
Equilibrium, (ii) Separating Equilibrium. In pooling equilibrium, senders (good firm and
bad firm) send the same type of signal, while in separating equilibrium, senders send
different types of signal.

First, let us consider the Pooling equilibrium cases:

Case 1: Both the firms signal H.

The game starts with both firms playing H. The receiver ( the investor) does not know
whether it's coming from good firm or bad firm. So, with no prior knowledge, he will
consider that a signal coming from good and bad has equal probability, i.e. ½. Now, the
investor will check its expected payoff from both the actions.

EU(I) = ½(R -C ) + ½{R - C - λ(R)} = R - C - ½{ λ(R)}

EU(E) = ½{ C - β(R)} + ½(C) = C - ½{β(R}

EU(I) = EU(E)

⇒ R - C - ½{λ(R)} = C - ½{β(R}

⇒ C = [ R + ½{β(R} - ½{λ(R)}] / 2 = c* (We consider)

If C < = C*, then EU(I) > EU(E) i.e, Investor will play I.

Now, when both the senders know Investor plays I , they will check if there is any
incentive to deviate to the other action.

For G : u - s(g) - p > u - s(g) - p - l

⇒ Playing H is better than playing L.Hence, there is no incentive to deviate.

For B : u - s(b) - kp < u - s(b) - l

⇒ Playing L is better than playing H. Thus, there is incentive to deviate. Now in that
case, Investor plays with belief ‘q’ and compares the expected payoff in that situation.

EU(I) = q(θR - C) + (1 - q){θR - C - λ(θR)}= θR + (q-1)λ(θR) - C

EU(E) = q{ C - β(θR)} + (1 - q) = C - q{β(θR}

Investor will exit if, EU(I) < EU(E),

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AI Washing: A game theoretic analysis of deceptive market practices

⇒ θR + (q - 1)λ(θR) - C < C - q{β(θR}

⇒ q <{2C + λ(θR) - θR} / {λ(θR) + β(θR} = q* (We assume it).

So, it’s better for B to not deviate as this will fetch him a lower payoff.

Case 2: Both the Firms signal L:

Investor will try to maximize its expected utility given that both player signals L:

EU(I) = ½{ θR - C } + ½{θR - C - λ(θR)} = θR - C - ½{θR)

EU(E) = ½{C - β(θR)} + ½(C) = C - ½{β(θR}

If EU(I) = EU(E)

⇒ θR - C + ½{θR) = C - ½{β(θR}

⇒ C = θR - ½{λ(θR)} + ½{β(θR)} = C*

If C < = C*, EU(I) > EU(E) ⇒ Investor will play I

Now given that investor will Invest, firms will check whether it is optimal for both types
to signal L.

For G: {u - s(g) - p - l} < {u - s(g) - p} , since l>0, by assumption

Hence, there is incentive to deviate.

For B: u - s(b) - l > u - s(b) - kp , since kp>l, by assumption

Hence, there is no incentive to deviate.

Now, If G deviates and signals high, investor will compare its expected utility from -

EU(I) = m (R - C) + (1-m){R - C - λ(R)}

EU(E) = m{C - β(R)} + (1-m)C

EU(I) > EU(E)

⇒ m (R - C) + (1-m){R - C - λ(R)} = m{C - β(R)} + (1-m)C

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AI Washing: A game theoretic analysis of deceptive market practices

⇒ m < (R - λ(R) -2C} / {2C - λ(R) -β(R)}=m*

Given that investor will invest it is still a better option for G type to deviate and signal H for
m<=m*

So, there will be no pooling equilibrium on low.

Next, we consider the Separating Equilibrium case:

G plays H and B plays L (we do not consider the case, where G plays L and B plays H as
it does not make sense.). Here, investor’s complete set of action is, if H then I and if L
then E.

● G plays H ⇒ Investor plays I, as (R - C) > { C - β(R) } ⇒ R + β(R) > 2C [We

assume]
● B plays L ⇒ Investor plays E, as {θR - C - λ(θR)} < C [We assume]

Now, we can see that G has no incentive to deviate.

However, if L deviates and plays H, Investor will play I, in which case:

u - s(b) - kp > -s(b) - l ⇒ An incentive to deviate.

Hence, we find that there can be no Separating Equilibrium in this particular game.
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AI Washing: A game theoretic analysis of deceptive market practices

Conclusion

In this paper, we have used a Signaling Framework to understand AI Washing from a game theoretic
angle. This analysis explores the concept of AI washing through the lens of a Signaling game. The model
suggests that firms strategically signal their AI capabilities to attract investors. The equilibrium reached
here is a pooling equilibrium where both the Good type (G) and Bad type (B) firms signal HIGH usage of
AI in their technologies.

This behavior explains the prevalence of AI washing. It is natural for the G type firms to signal High or its
actual usage of AI but through the equilibrium we are able to explain that the optimal strategy for the B
type firms is to mimic the signals of the G type firms., which is to exaggerate its AI usage and also signal
High, which actually explains the AI Washing phenomenon. The B type firms falsely signal the same as
the G type firms and resort to deceptive marketing tactics to create an illusion of advanced AI
technology. Hence we conclude that the model in this paper effectively captures this phenomenon,
highlighting the incentive for firms with lesser AI usage to engage in AI washing.
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AI Washing: A game theoretic analysis of deceptive market practices

References

● ‘Greenwashing Premium’ written by Eric Tham, March 2023

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4310211

● ‘What is AI Washing, and why are companies being fined for it?’ written by Aaron
Drapkin, published in Tech.co
https://tech.co/news/what-is-ai-washing-companies-fined

● ‘US SEC, two investment firms settle AI – related charges, published by Telecom from
The Economic times.
https://telecom.economictimes.indiatimes.com/news/internet/us-sec-two-investment-fi
rms-settle-ai-related-charges/10859308

● The rise of 'pseudo-AI': how tech firms quietly use humans to do bots' work ( July 2018)
https://www.theguardian.com/technology/2018/jul/06/artificial-intelligence-ai-humans-bots-tech-comp
anies

● Don't be fooled: The threat of AI - Washing to Indian consumers

https://m.economictimes.com/opinion/et-commentary/dont-be-fooled-the-threat-of-ai-
washing-to-indian-consumers/articleshow/109894185.cms