Game Theory James Oldroyd Kellogg Graduate School of Management Northwestern University...

Game Theory

James OldroydKellogg Graduate School of ManagementNorthwestern University

[email protected] TNRB

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The Game of Business is about adding value

Free-wheeling games• A player cannot take more out of a game than his or her

value addedStructured games

• Look forward to determine the outcomes, then reason backward to determine the best strategy

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Free-wheeling Games

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Co-opetition Combines Cooperation and Competition

Cooperation affects the size of the pie

Competition affects the market share --size of the slice

Profit is the product of the size of the pie and the market share

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Allocentrism

Focus on others

Homeland Security Office’s New Department

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GM Credit Cards

What was competitors response?

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Substitutors ComplementorsCompany

Customers

Suppliers

Source: Adam Brandenburger and Barry Nalebuff, Co-opetition(New York: Currency Doubleday, 1996), p. 17

The Value Net

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A player is your substitutor with respect to customers if customers value your product less when they have the other player’s product as well

Customers

Firm

Suppliers

Substitutors Complementors

A player is your complementor with respect to customers if customers value your product more when they have the other player’s product as well

A player is your complementor with respect to suppliers if it is more attractive for a supplier to provide resources to you when it is also supplying the other player

A player is your substitutor with respect to suppliers if it is less attractive for a supplier to provide resources to you when it is also supplying the other player

The Value Net

Source: Adam Brandenburger and Barry Nalebuff, Co-opetition (New York: Currency Doubleday, 1996)

Coke and Pepsi

Coke and Tyson Foods

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Changing the game

First: Identify the players and draw the value net Second: identify the elements of the game (PARTS)

• Players, Added values, Rules, Tactics, Scope

Change one or more of these elements No elements of the game should be considered

fixed and unchangeable

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Players

HSC

Coke and

Pepsi

Monsanto

From To

Monsanto

Value Change?

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Value Add

Bell South

How much value does a firm add?

That is how much value they can take away.

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Change the Rules

Judo Economics

“Players who live in glass houses are unlikely to throw stones.”

One problem: Exit barriers

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Tactics

Lift the Fog - Newspapers in

NYC Create Fog

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Changing the Scope

No game is an island

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Structured Games

The game has a more formal structure: there are rules and a reasonably small set of possible outcomes

The basic rule for structured games is “to look forward to determine the outcomes and then reason backward to determine the best action”

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Hot Dog Stands on a Beach Oscar and Meyer decide to sell hot dogs on a beach. They are

required to sell the hot dogs at the same price and the hot dogs are undifferentiated. The sunbathers are distributed equally along the beach. Where should Oscar and Meyer locate their hot dog stands?

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Game Theory: payoff matrix

There are two (or more) players, each of whom has a finite number of options

List the choices for each player on one of the axesEach cell in the matrix represents the payoff (reward to a player)

resulting from choosing an option assuming that the other player will choose a particular option

Usually the payoffs for both players are given in the same cell, separated by a diagonal slash or as an ordered pair (row, column)

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The Prisoner’s Dilemma

Al

Joe Confess Don’t Confess

Confess (-8, -8) (0, -15)

Don’t Confess

(-15, 0) (-1, -1)

How will the game turn out?

Two vagrants, Al and Joe, have been arrested for vagrancy. The DA suspects them of complicity in a robbery, but she doesn’t have enough evidence to convict them. (Al and Joe don’t know this for sure.) The DA interrogates each of them separately and offers the following deal:

“If you confess and your friend does not, you will be released and I will throw the book at your friend. I have made the same offer to your friend.” Assume the relevant prison times (in months) are as follows:

Source: Pete Clarke BYU 2002

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The Rational Pigs

Dominant Pig:

Subordinate Pig:

Press Don’t Press

Press (1.5, 3.5) (-0.5, 6)

Don’t Press (5, 0.5) (0, 0)

Two pigs, one dominant and one subordinate, are in a pen. There is a lever at one end of the pen which, when pressed, dispenses 6 units of food into a trough at the other end of the pen. Thus, a pig that presses the lever must run to the other end of the pen before it can eat. By the time it gets there, the other pig may have eaten some or most of the food. The dominant pig is able to prevent the subordinate pig from getting any of the food when both are at the trough. Assume it requires energy equivalent to ½ unit of food to run from one end of the pen to the other. Suppose that if both of the pigs press the lever, the subordinate pig is faster than the dominant pig and can eat two units of food before the dominant pig gets to the food. Which pig will press the lever?

Payoff matrix:


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Boeing, Airbus and the super-jumbo airframe (1991)

BoeingAirbus

Develop

Develop

Doesn’t Develop

Doesn’t Develop

(A/B)

(6-8+5=3 / 9-8=1)

(-1/12)

(15-3=12/ -6)

(-2/15-8=7)

Market =$15b, Development Cost=$8b, Airbus subsidy=$5b


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How Will the Game Turn Out?

It is the rational pig situation: Airbus has a dominant strategy: introduce the super jumbo. Boeing’s strategy depends on what Airbus does. Since Airbus will introduce, Boeing will introduce also

But Boeing’s strongly preferred solution is for neither to introduce the super jumbo so it can continue its 747 monopoly!

Therefore, Boeing must find ways to change the game!!


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How Boeing Has Changed the Game

Change players: Jan 1993, Boeing invites Deutsche Aerospace to be its partner in super jumbo development (Nearly splits up Airbus) (Great fun in the newspapers!!!)

Change tactics (perceptions) and added values: June 1995, Boeing announces that the market wants a supersonic—not a super jumbo (it builds neither!)

Change rules: (constantly) Petition the WTO and EU to ban subsidies to Airbus

December 1999 Airbus announces it will develop a super jumbo (None has been built, yet!)

Boeing has delayed super jumbo introduction by 9 years (so far). Value of playing the game = $117billion (9 years @ $ [12b-(-1b)]


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Traps of Strategy

Not understanding the present gameBelieving you must accept the present gameThinking that change must come at the expense of another

player (win-lose)Believing you must do something uniqueFailing to see the whole gameFailing to think methodicallyFailing to think dynamicallyNot expecting another player will change the game

Pay-offs in Europe

HSCNutraSweet

Fight$25/lb

Accom$50/lb

($25 - 25) x0 tonnes x2,205 lb/tonne) =

$0 mm($50 - 25) x500 tonnes x2,205 lb/tonne) =

$28 mm


$56 mm

$ ($25 - 18) x1,300 tonnes x2,205 lb/tonne) =

$20 mm

contribution margins

Bitter Competition (1987-89)

1987-HSC launches; 500-tonne plant on stream in 1988; no branding; customer can blend.

Feb. 1987-NS responds to complaints by Euro-pean commission; opens 50% of European contracts with Coke & Pepsi to competitive bidding. Both gave HSC “some” business.• NS bombs price to $22-30. Angus Chemical & 3 Italian firms exit; no

other entrants.

In 1981, NutraSweet in Canada was $90/lb. As HSC entered, NS lowers price to $40-$50/lb.• HSC finds that NS signed Coke & Pepsi to exclusive, multi-yr contracts

that include:– “Meet or Release” clauses -- give NS the right to meet any

price by a competitor– “MFN” clauses -- NS guarantees the price charged to

Coke/Pepsi would match the lowest price to the other competitor.

Bitter Competition (1989-91)Late 1989, NS announces plan to double capacity at Augusta to 6,000 tonnes (1991

demand forecast: 8,000 tonnes in U.S.; 10,000 tonnes worldwide.)

HSC lodges dumping complaint with EC; Nov. 1990, EC levies $15/lb duty on NS imports.

HSC files complaint in Canada: “NS dropped prices in Canada to $23-34 and forced buyers to sign exclusive contracts to drive us from the mkt.” • Oct. 1990-Canadian court prohibits NS’s use of 1) exclusive contracts, and 2)

discounts in exchange for exclusivity or use of the NS logo on products. • Also prohibits NS from “MOR” clauses, and requires that “MFN” clauses be

offered to all customers or none (not just Coke and Pepsi)• HSC:“We are convinced that NS’s game plan has been to drive us out of

business and then retain the mono-poly. All we have ever wanted is a level playing field.”

HSC disputes NS patents in US• June 1991, NS’s blend patent is struck down.

Bitter Competition (mid-1991)

September 1991, NS-Ajinomoto joint venture announces $130 million plan to build 2,000 tonne plant near Dunkirk in France. • Plant will come on stream in summer of 1993.

Game through mid-1991

1985: HSC formed; Monsanto acquires Searle

1986: HSC begins building 500-tonne plant• HSC files complaint with EC

1987: NS use patents expire in EC and Canada• NS drops exclusivity clauses in EC with Coke/Pepsi• HSC starts selling aspartame

1988: HSC files complaint in Canada

1989: HSC tries to invalidate NS patents in US• NS announces plan to double Augusta capacity

1990: HSC lodges dumping complaint in EC & wins $15 dumping duty on NS imports• Canada disallows NS contracting practices

1991: NS-Ajinomoto announce plan to build 2,000-tonne plant in France

Bitter Competition (late 1991)Worldwide demand and price:

• US: 8,000 tons @ $50-70/lb • EC: 1,400 tons @ $37-40/lb (reflecting $15 duty)• Canada: 400 tons @ $30 per lb• RoW: 200 tons

HSC has 30% of EC and 5% of Canada

Soft drinks = 80% of aspartame sales; Coke and Pepsi = 70% of soft drink market

Tabletop aspartame grows rapidly in US; NS earning 30% on $200 million with Equal. Equal had 54% market share; Sweet’N Low had 31%.

NS builds 25-person service/sales staff to provide customer assistance and mkt research to customers.

Shapiro named President of Monsanto Agriculture. New CEO Robt Flynn offers dedicated sales force to serve Coke/Pepsi, plans to cut mfg cost 60%.

Monsanto profits drop: $679m in ‘89 to $296 in ‘91

Pay-offs in the US


HSCNutraSweet

Fight$25/lb

Accom$50/lb


$0 mm

($50 - 25) x1,500 tonnes x2,205 lb/tonne) =

$83 mm


$473 mm


$141 mm

Pay-offs in the US


HSCNutraSweet

Fight$25/lb

Accom$50/lb


$0 mm


$110 mm


$437 mm


$141 mm

Bitter Competition (early 1992)

January: HSC announces $55 million plant to increase capacity to 2,000 tonnes at Geleen, Holland. Scheduled to come on line in late 1993.

January: HSC says that it expects to garner 10-20% of the US market for aspartame, and it would continue to expand capacity as needed.

January: Vermijs states that “the expansion of HSC’s plant in Europe is an important step for us as the greater economy of scale and added volume will allow us to compete globally.”

March: VP HSC in US: “Every manufacturer likes to have at least two sources...[we are] looking forward to moving the war in the U.S.”

(Remember: on December 14, 1992, the NS aspartame patent in US will expire.)

Bitter Competition (mid-1992)

February 1992, NS launches $10 million campaign for Equal (starring Cher!).

April 1992, Pepsi announces new long-term global supply contract with NS. Coke discloses it signed similar deal in December.

Analysts estimated that Coke and Pepsi would save $200 million per year over next 2-3 years, as prices drop to “low $30s” / lb.

Coke announces it has a worldwide agreement with HSC as well as NS. Analysis indicates that it is for a very small volume.

Debrief

Dynamics of competition• Allocentrism

Once it entered, HSC had no added value• Total value created with HSC in the world = total value created

without HSC in the world• Since HSC added no value, it could expect to capture no value

once it entered

HSC’s entry substantially changed the division of value, however -- in favor of Coke and Pepsi

If your entry shifts the division of value but creates no new value, GET PAID TO PLAY!!!• Put differently: As a provider of aspartame, HSC was a weak

second player. As a provider of competition in the market for aspartame, HSC was a monopolist

Know your effect on the creation and division of value, and exploit it!!!

Debrief

Capacity preemption

Signaling

Credibility

Legal maneuvers (exploiting non-market forces)

Branded ingredients

Creative contracting

Lessons:Probably not a good idea to incite a price war when you are not the low cost playerInterpretation of signals

• HSC’s aggressive statements – Try not to anger competitors...

Distinguish between Strategy & Tactics• Strategy:

– Defining the nature of competition– Making potentially decisive moves

· building brand, scale• Tactics:

– How the game is played· pricing, capacity, legal

– responses depend on perceptions NutraSweet defined the game; HSC acted only as a spoiler -- bargaining chipHSC should have ‘gotten paid to play’

• “monopolist” in making the market competitive, but never got compensated

NutraSweet, by contrast, used their 7 yrs of plenty to prepare for 7 years of famine

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Kmart and Wal-mart

Why doesn’t Kmart and Target attach Wal-mart in their home turf?

The importance of pre-emption

“Those who win every battle are not really skillful…

Those who render others’ armies helpless without fighting are the best of all”

Sun Tse

Game Theory James Oldroyd Kellogg Graduate School of Management Northwestern University...

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