Game Theory
James Oldroyd
Kellogg Graduate School of Management
Northwestern University
j-oldroyd@northwestern.edu
801-422-7888
650 TNRB
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 added
Structured games
• Look forward to determine the outcomes, then reason
backward to determine the best strategy
1
Free-wheeling Games
2
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
3
Allocentrism
Focus on others
Homeland Security Office’s New
Department
4
GM Credit Cards
What was
competitors
response?
5
The Value Net
Customers
Substitutors
Company
Complementors
Suppliers
Source: Adam Brandenburger and Barry Nalebuff, Co-opetition
(New York: Currency Doubleday, 1996), p. 17
6
The Value Net
Coke and Pepsi
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
Substitutors
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
Coke and Tyson
Foods
Customers
Firm
Suppliers
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
Complementors
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
Source: Adam Brandenburger and Barry Nalebuff,
Co-opetition (New York: Currency Doubleday, 1996)
7
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
8
Players
To
From
Coke
and
Pepsi
Monsanto
Monsanto
HSC
Value Change?
9
Value Add
Bell South
How much value does a firm add?
That is how much value they can
take away.
10
Change the Rules
Judo Economics
“Players who live in glass houses are unlikely to
throw stones.”
One problem: Exit barriers
11
Tactics
Lift the Fog Newspapers in
NYC
Create Fog
12
Changing the Scope
No game is an island
13
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”
14
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?
15
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 axes
Each 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)
16
The Prisoner’s Dilemma
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:
Al
How will the game turn out?
Joe
Confess
Don’t Confess
Confess
(-8, -8)
(0, -15)
Don’t Confess
(-15, 0)
(-1, -1)
Source: Pete Clarke BYU 2002
17
The Rational Pigs
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:
Dominant Pig:
Subordinate Pig:
Press
Don’t Press
Press
(1.5, 3.5)
(-0.5, 6)
Don’t Press
(5, 0.5)
(0, 0)
Source: Pete Clarke BYU 2002
18
Boeing, Airbus and the
super-jumbo airframe (1991)
Boeing
(A/B)
Airbus
Develop
Develop
(6-8+5=3 /
9-8=1)
Doesn’t
Develop
(-2/15-8=7)
Doesn’t Develop
(15-3=12/ -6)
(-1/12)
Market =$15b, Development Cost=$8b, Airbus subsidy=$5b
Source: Pete Clarke BYU 2002
19
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!!
Source: Pete Clarke BYU 2002
20
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)]
Source: Pete Clarke BYU 2002
21
Traps of Strategy
Not understanding the present game
Believing you must accept the present game
Thinking that change must come at the expense of another
player (win-lose)
Believing you must do something unique
Failing to see the whole game
Failing to think methodically
Failing to think dynamically
Not expecting another player will change the game
22
Pay-offs in Europe
contribution margins
NutraSweet
Fight
$25/lb
$ ($25 - 18) x
1,300 tonnes x
2,205 lb/tonne) =
$20 mm
Accom
$50/lb
HSC
($25 - 25) x
0 tonnes x
2,205 lb/tonne) =
$0 mm
($50 - 18) x
800 tonnes x
2,205 lb/tonne) =
($50 - 25) x
500 tonnes x
2,205 lb/tonne) =
$56 mm
$28 mm
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;
drink market
Coke and Pepsi = 70% of soft
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
contribution margins
NutraSweet
Fight
$25/lb
Accom
$50/lb
HSC
($25 - 17) x
8,000 tonnes x
2,205 lb/tonne) =
($25 - 25) x
0 tonnes x
2,205 lb/tonne) =
$141 mm
$0 mm
($50 - 17) x
6,500 tonnes x
2,205 lb/tonne) =
($50 - 25) x
1,500 tonnes x
2,205 lb/tonne) =
$473 mm
$83 mm
Pay-offs in the US
contribution margins
NutraSweet
Fight
$25/lb
Accom
$50/lb
HSC
($25 - 17) x
8,000 tonnes x
2,205 lb/tonne) =
($25 - 25) x
0 tonnes x
2,205 lb/tonne) =
$141 mm
$0 mm
($50 - 17) x
6,000 tonnes x
2,205 lb/tonne) =
($50 - 25) x
2,000 tonnes x
2,205 lb/tonne) =
$437 mm
$110 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
player
Interpretation 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 chip
HSC 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
Kmart and Wal-mart
Why doesn’t Kmart and Target attach Wal-mart in
their home turf?
36
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