competitive and cooperative dynamics

Strategy Ramon Casadesus-Masanell, Series Editor

+ INTERACTIV INTERACTIVE E ILLUSTRATIONS ILLUSTRATIONS

Competitive and Cooperative Dynamics RAMON CASADESUS-MASANELL

HARVARD BUSINESS SCHOOL

8131

| Published: June 30, 2015

This document is authorized for educator review use only by ALEJANDRO CAT CATALDO, University of Atacama until May 2018. Copying or posting is an infringement of copyright. [email protected] [email protected] or 617.783.7860

Table of Contents

1 Introduction.................................................................................................................................................................. Introduction.................................................................................................................................................................. 3 2 Essential Reading Reading .................................................................................................................................................4 2.1 Types of Strategic Interaction Interaction ......................................................................................................4 2.2 Preparing for the Game Game .......................................................................................................................7 ................................................................7 What You Bring to the Game: Added Value Value ................................................................7 Anticipating the Game: Interdependencies, Player Analysis, ........................................................................................................................................ 8 and Game Theory Theory........................................................................................................................................ ....................................................................................................23 2.3 Playing to Win (or Win-Win) Win-Win) ....................................................................................................23 Changing Added Value: Commitments and Capabilities .......................... Capabilities .......................... 23 ........................................................................................24 Changing the Scope of the Game Game ........................................................................................24 ................................................................. 25 Changing the Boundaries: Linking G ames ames .................................................................25 2.4 Conclusion Conclusion ......................................................................................................................................................26 26 ................................................................................................................................26 3 Supplemental Reading Reading ................................................................................................................................26 ........................................................................... 26 3.1 Reaction Curves and Price Leadership Leadership ...........................................................................26 ......................................................................................................................29 3.2 Gathering Intelligence Intelligence ...................................................................................................................... 29 4 Key Terms Terms ...................................................................................................................................................................31 31 ......................................................................................................................................32 5 For Further Reading Reading ......................................................................................................................................32 6 Endnotes Endnotes .....................................................................................................................................................................33 33 7 Index Index ................................................................................................................................................................................34 34

This reading contains links to interactive illustrations and video, denoted by the icons above. To access these exercises, you will need a broadband Internet connection. Verify that your browser meets the minimum technical requirements by visiting http://hbsp.harvard.edu/list/tech-specs. Ramon Casadesus-Masanell, Herman C. Krannert Professor of Business Administration, Harvard Business School, developed this Core Reading with the assistance of Sunru Yong, Harvard Business School MBA 2007.

Copyright © 2015 Harvard Business School Publishing Corporation. All rights reserved.

8131 | Core Reading: COMPETITIVE AND COOPERATIVE DYNAMICS

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Table of Contents

1 Introduction.................................................................................................................................................................. Introduction.................................................................................................................................................................. 3 2 Essential Reading Reading .................................................................................................................................................4 2.1 Types of Strategic Interaction Interaction ......................................................................................................4 2.2 Preparing for the Game Game .......................................................................................................................7 ................................................................7 What You Bring to the Game: Added Value Value ................................................................7 Anticipating the Game: Interdependencies, Player Analysis, ........................................................................................................................................ 8 and Game Theory Theory........................................................................................................................................ ....................................................................................................23 2.3 Playing to Win (or Win-Win) Win-Win) ....................................................................................................23 Changing Added Value: Commitments and Capabilities .......................... Capabilities .......................... 23 ........................................................................................24 Changing the Scope of the Game Game ........................................................................................24 ................................................................. 25 Changing the Boundaries: Linking G ames ames .................................................................25 2.4 Conclusion Conclusion ......................................................................................................................................................26 26 ................................................................................................................................26 3 Supplemental Reading Reading ................................................................................................................................26 ........................................................................... 26 3.1 Reaction Curves and Price Leadership Leadership ...........................................................................26 ......................................................................................................................29 3.2 Gathering Intelligence Intelligence ...................................................................................................................... 29 4 Key Terms Terms ...................................................................................................................................................................31 31 ......................................................................................................................................32 5 For Further Reading Reading ......................................................................................................................................32 6 Endnotes Endnotes .....................................................................................................................................................................33 33 7 Index Index ................................................................................................................................................................................34 34

This reading contains links to interactive illustrations and video, denoted by the icons above. To access these exercises, you will need a broadband Internet connection. Verify that your browser meets the minimum technical requirements by visiting http://hbsp.harvard.edu/list/tech-specs. Ramon Casadesus-Masanell, Herman C. Krannert Professor of Business Administration, Harvard Business School, developed this Core Reading with the assistance of Sunru Yong, Harvard Business School MBA 2007.

Copyright © 2015 Harvard Business School Publishing Corporation. All rights reserved.


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1 INTRODUCTION

A

firm’s strategy comprises choices about its positioning and business model—in other words, where and how it will compete. An effective strategy enables a firm to generate superior returns over the long run.

Every firm exists in a world with other self-interested players, all vying to maximize their returns. Thus, business is not static in the long run or the short run. Every business faces a dynamic environment marked by uncertainty and contingencies. No choice is made in a vacuum. Actions beget reactions, and strategies

shift.

A

firm’s

relationships

with

other

organizations

may

be

competitive, cooperative, or sometimes both. Rival firms contribute to these dynamics, but buyers, suppliers, and complementary businesses can also play critical roles. Together, these other players can constrain or enhance the value that a firm creates and captures. What are the consequences of an action? How will other players respond? A firm ignores such questions at its peril. The firm that thrives understands its interdependencies with other players and wisely anticipates the consequences of its choices.

Imagine a small fishing village where rival boatbuilders compete to supply fishermen throughout the region. The boatbuilders have passed their skills down from one generation to the next, producing boats that can navigate the local waters. They create tremendous value for the fishermen, who would otherwise be left without the means to go to sea. However, the boatbuilders capture little of this value for themselves. Because all of them are producing similar boats with equal capabilities, the fishermen can drive hard bargains, leaving the builders with very modest profits. Now suppose one of the local boatbuilders, the Innovator, introduces a new design: an outrigger boat with a timber frame, carvel planking, and a lateen sail design. The new outrigger enables fishermen to sail safely into much deeper waters, where the catch is consistently more plentiful. As word spreads, the Innovator can barely keep pace with orders. The new outrigger fetches a much higher price than the other builders’ boats do. Not surprisingly, the Innovator keeps the building techniques for her design a closely guarded secret. It is important to note that the Innovator has not succeeded alone. The new design requires special timber, which the Innovator purchases from a Woodcutter who has found a supply deep in the forest. To be used, the timber requires a process that the Innovator and the Woodcutter have developed together. In addition, the boat’s lateen sails require rugged materials and stitching that can handle the stronger winds that come with the boat’s deep sea range. For this, the Innovator has partnered with the village Sailmaker. The sails of the outrigger require more frequent repair and replacement, providing the Sailmaker with a steady stream of business. While sales for the Innovator, the Woodcutter, and the Sailmaker increase rapidly, rival boatbuilders see their business shr ink dramatically. Clearly, the Innovator’s business has profoundly affected those around her, changing the way value is created and distributed within the fishing village. The responses of other boatbuilders will, in turn, have implications for the Innovator. Her newfound success will surely spur others to imitate or supplant her. Her joint efforts with the Woodcutter and Sailmaker have led to mutual benefits, yet it is unclear whether such cooperation is sustainable.


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In this Core Reading, we examine how firms interact, both competitively and cooperatively, as they create and capture value. In a dynamic environment, can a firm predict the actions—or reactions—of other players? How do the insights it gains through such predictions help its managers make the best choices? When players cooperate—as the Innovator, the Woodcutter, and the Sailmaker do—how can their efforts be sustained? Strategists and academics typically cast interactions between firms as a game, and we will do the same in this reading. We will consider how to assess critically what a firm brings to the game and the implications of what it brings for how effectively it can play. We will introduce ways to analyze interdependencies among players, the perspectives and incentives of others, and identify how these shape the nature of the game being played. This discussion provides the foundation for an introduction to game theory, which provides a rigorous way to analyze economic payoffs for players under various scenarios. Finally, we will discuss how a firm can change the game in its favor.

2 ESSENTIAL READING 2.1 Types of Strategic Interaction The competition between the Innovator and the other boatbuilders and the cooperation between the Innovator and the Woodcutter are both strategic interactions because the business model of each firm affects the performance of the other firms. Competition among rival firms is one type of strategic interaction, but the term also applies to other kinds of interactions. A firm’s business model affects, and is affected by, competitors, suppliers, customers, and complementors. Interactions with each player have different implications for the firm. To understand these dynamics, we can map strategic interactions along two dimensions.1 The first dimension involves whether the interaction results in value creation or value capture. Each concept raises different questions for a business. It may be helpful to remember them by employing the pie metaphor often used to describe economic value: Value creation: How big is the pie? What would make the pie bigger? Value capture: How will we divide the pie? Am I getting my fair share or more than my fair share?

Consider how these concepts play out in the fishing village: The boatbuilders create value by providing fishermen with equipment to make a living. Similarly, the woodcutters create value by supplying raw materials to the boatbuilders. Their interaction creates tremendous value for the village’s fishing sector. The value they create may be very different, however, from the value they capture. The key to value capture is scarcity. Imitation and substitution reduce scarcity. In the fishing village, the boatbuilders all sell the same standard boat and, as a group, easily meet market demand. The boats are not scarce, and therefore the boatbuilders capture relatively little of the value they create. It is the same for the woodcutters—their skills are easily learned, and their timber comes from an abundant forest. On the other hand, the maker of the new outrigger is the only one in the village with the know-how to build that particular boat. Until others learn to provide an acceptable imitation or substitute, the Innovator’s skill is scarce. She creates more value than other builders do because those who


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This document is authorized for educator review use only by ALEJANDRO CATALDO, University of Atacama until May 2018. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860

use her boats catch significantly more fish, and the scarcity of her skill enables her to capture a far greater share of this value. The second dimension of strategic interactions is whether they are competitive interactions or cooperative interactions. Again, the pie metaphor may be helpful: Competitive interaction: How might others shrink the pie or my share of it? Cooperative interaction: How might I work with others to make the pie—or my share of it—bigger?

An interaction is competitive if one firm’s business model causes another firm to create or capture less value. The interactions of direct rivals—woodcutters, boatbuilders, or sailmakers—are competitive. If the population of fishermen is not growing dramatically, each set of rivals is fighting for a piece of a fixed pie. In a cooperative interaction, the opposite is true. One firm’s business model boosts the other’s ability to create or ca pture value. Take, for example, the Innovator’s collaboration with the Woodcutter and the Sailmaker to develop the special timber and the lateen sails, respectively. Each player is an important part of the outrigger ecosystem; they have jointly agreed on the design and quality standards and are privy to inside information about one another’s businesses. The Woodcutter sells exclusively to the Innovator, and every outrigger sold means more demand for his special timber. Similarly, the Sailmaker’s lateen sails fit the outrigger only and no other fishing boat, so each additional outrigger on the water increases demand for the repair and replacement of sails. Clearly, the success of the Innovator’s business has become integral to the success of the Woodcutter and the Sailmaker. As a cooperative group, they have created and grown their own pie while shrinking the pies of their respective rivals. Figure 1 shows how these two dimensions describe the four kinds of strategic interaction and pr ovides an example for each. FIGURE 1 Four Types of Strategic Interactions

Source: Adapted from Harvard Business School, “A Note on Strategic Interaction,” HBS No. 714-417 by Ramon Casadesus-Masanell. Copyright 2013 by the President and Fellows of Harvard College; all rights reserved.

The matrix in the figure reveals two important insights. First, it reminds us that a firm’s place in its ecosystem must be viewed holistically . Competition and cooperation are mirror-


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image concepts, and both must be incorporated into strategy. Competitive battles for market share are too often the only focus of strategists. It is reductive—and dangerous—to see business only as a win-lose proposition. Opportunities to cooperate with other organizations, even competitors, for win-win outcomes may be just as important in a firm’s success. On her own, perhaps the Innovator can still create and capture more value than any other boatbuilder in the village does. By collaborating with other firms, however, the Innovator may have created a stronger, more sustainable business model that is even harder for her rivals to compete against. This leads us to the matrix’s second, subtler insight. The interaction between two firms must also be viewed dynamically . A given relationship may be manifested in more than one quadrant in the matrix. A cooperative dynamic can also be competitive, and vice versa. For example, the competing boatbuilders vie for market share among the fishermen. They may compete fiercely, but they may also cooperate to drive down the price of timber from woodcutters. Likewise, a cooperative interaction between strategic allies can be competitive. Our Innovator has worked with the Sailmaker on the product design, and the completed outrigger is sold as a bundled product. This cooperation has benefited both firms. Having created more value by cooperating, however, they must now decide how to divide the value between themselves. Each may seek ways to improve its bargaining position against the other in order to claim a greater share. Barry Nalebuff and Adam Brandenburger, experts on the application of game theory to business strategy, use the term co-opetition to describe simultaneous cooperation and competition between firms. For instance, Intel and Microsoft are complementors : companies from which customers buy complementary products or to which suppliers sell c omplementary resources. In the case of Intel and Microsoft, Intel’s more powerful processors increase customer demand for Microsoft’s software, and vice versa. The more these firms optimize their products to work together and coordinate their introductions of new generations, the more powerful this relationship becomes. Their cooperation is why IBM, Hewlett-Packard, and other personal computer manufacturers saw their share of the IT industry’s pie shrink during the 1990s. Yet, as Section 2.2 will discuss, the interests of Intel and Microsoft are not fully aligned because these firms still compete for value. They exist in a state of co-opetition. In another example, United Airlines and American Airlines are competitors, operating out of the same cities, flying the same routes, and competing for many of the same customers. However, they may cooperate to a limited degree when it comes to the supply of new airplanes. Boeing cannot afford to design, develop, and manufacture a new plane unless enough airlines commit to buying it. By purchasing the same model of passenger jet, United and American each make the other’s airplanes more affordable. In this instance, they are complementors.2 Figure 2 shows co-opetition in strategic interactions, using the airline industry.


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FIGURE 2 Co-opetition in Strategic Interactions

Source: Adapted from Harvard Business School, “A Note on Strategic Interaction,” HBS No. 714-417 by Ramon Casadesus-Masanell. Copyright 2013 by the President and Fellows of Harvard College; all rights reserved.

The takeaway is that strategic interactions are neither purely win-lose nor purely win-win. Forgetting that both competitive and cooperative elements can exist simultaneously can lead to missed opportunities to create or capture value. The purpose of this reading is not simply to categorize strategic interactions. Rather, it is to understand what we can do to make the most of every competitive and cooperative interaction. How can a firm position itself most advantageously? How can it achieve—and sustain—superior performance? In the next sections, we will look at how a firm prepares for, anticipates, and plays the game of strategic interaction.

2.2 Preparing for the Game

What You Bring to the Game: Added Value How does a firm prepare to play the game of strategic interaction? A good place to start is the ancient adage, “Know thyself.” What will the firm bring to the game? Put another way, what is its added value: the value it creates and captures, which is determined by the scarcity of its capabilities and what it offers? (For more on added value, see Core Reading: Competitive Advantage [HBP No. 8105].) It is natural for a firm to believe that its added value is significant; what company thinks it is not important? A boatbuilder producing standard boats for fishermen might argue that he has a lot of added value. However, we have seen that this is not the case in our fishing village; too many others offer exactly the same thing. True added value is the value that would disappear if the firm ceased to exist. This is a discomfiting, sobering line of thinking, but it is the right acid test. Brandenburger and Nalebuff memorably described it not as simply reading your obituary, but reading the newspaper one year after


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your death to see how the world has managed without you. In terms of the economic pie, added value can be defined as follows:

If a firm disappeared, someone in its world—including suppliers, customers, and complementors—ought to miss it and not be able to replace it completely. Obviously, a firm that could be replaced without much trouble—one of the many boatbuilders producing the same boat, for instance—has little added value. On the other hand, a firm that offers something scarce, such as the Innovator, is difficult to re place. Her added value is very high. Failure to understand your true added value is a sure way to lose the game, or at least to have a disappointing outcome. Suppose the Woodcutter, confident in his position as the Innovator’s sole supplier, raises the price of the timber. Unfortunately, he has forgotten two important facts: The Innovator knows exactly where to find the right trees, and she helped develop the timber treatment process. In raising prices to capture more value, the Woodcutter is playing a dangerous game, one that he is likely to lose. The Innovator can teach other woodcutters how to supply the timber, dramatically reducing the original Woodcutter’s importance. On the other hand, the Woodcutter’s special timber will not fetch a premium from the other boatbuilders because none of them knows how to produce the outrigger. The Woodcutter has not recognized his true added value. Any new woodcutters who wish to supply the Innovator must also exercise caution. The Innovator may convince them to invest resources to become a supplier, but their added value, like that of the original Woodcutter, is also limited. Consider the cautionary tale of Holland Sweetener Company (HSC), as related by Brandenburger and Nalebuff.3 Coca-Cola and Pepsi-Cola had long used aspartame, a lowcalorie sweetener, for their diet sodas. Monsanto held the patent for aspartame, which it marketed under the brand name NutraSweet. With the encouragement of Coke, HSC built an aspartame plant in anticipation of the patent expiration. It expected to step into the profitable aspartame business and provide the sweetener for Diet Coke and Diet Pepsi. After all, what manufacturer does not want a second source for a key input? Unfortunately for HSC, it had not recognized the true game it was playing, which ended even before Monsanto’s patents expired. Both Coke and Pepsi signed new long-term contracts with Monsanto, getting exactly what they wanted—the same NutraSweet brand at a much better price. HSC’s entry was worth a lot because it reduced Monsanto’s added value and improved the bargaining position for Coke and Pepsi. What HSC failed to see was that its added value, once it entered the market and served its purpose, was very low.

Anticipating the Game: Interdependencies, Player Analysis, and Game Theory Determining added value is just the first step. The adage “Know thyself” was carved into the entrance of the Temple of Apollo at Delphi. Within the temple, supplicants could se ek counsel and prophecy from the famed Oracle of Delphi, who made pronouncements on political rule, war, colonies, and more. Alas, the modern strategist may follow the adage and have an excellent understanding of her firm’s added value, but she has no oracle to consult on business decisions. In lieu of divine insight, we turn to three analytical tools to help us anticipate how the game of business may play out. Each tool examines a different, but related, element of strategic interaction:


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Interdependencies: What choices can each player make and what are the consequences of those choices for other players? Player analysis: How does each player see its world and its choices? Game theory: What are the economic outcomes of various scenarios, and how do they affect each player’s likely choices?

Strategists are often egocentric, viewing the world solely through their own lens. This narrow approach may not account for the incentives, choices, and likely reactions of other players. Anticipating the game forces strategists to be allocentric, to look at the world from someone else’s perspective.

Interdependencies Earlier, we stated that strategic interactions occur when the business model of one firm affects the business model and performance of another firm. Analysis of interdependencies , the exact points at which the business model of one firm touches the business model of another, forces the strategist to ask the following questions: What key choices and consequences in our business models will shape the game? What can we do against each other, and what can we do with each other? Understanding business models and their interdependencies may determine what game is most likely to be played—competitive; cooperative; or, as is often the case, a mix of the two— and what plays should be considered. We can depict a firm’s key choices and their consequences in a simple diagram. Together, the choices and consequences should represent the economic logic, or business model, of the firm. Let us start with the Innovator’s business model, distilled to the most essential choices, as shown in Interactive Illustration 1. To see how the boatbuilder’s profits over time are affected by her choices about pricing and product improvements, slide the arrows for R&D spending and price up or down and decide whether the boatbuilder should have exclusive relationships with her supplier and complementor. A full rotation of the green dots represents a quarter year.


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INTERACTIVE ILLUSTRATION 1 Business Model for Boats Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2IRP3fH

Source: Adapted from Long Range Planning 43, no. 2, Ramon Casadesus-Masanell and Joan Enric Ricart, “From Strategy to Business Models and onto Tactics,” pp. 195–215, Copyright 2010 with permission from Elsevier.

By investing in the outrigger design and building a strong ecosystem with a complementor (the Sailmaker) and a supplier (the Woodcutter), the Innovator has created a superior product for which fishermen are willing to pay a premium. As a result, the Innovator enjoys significantly increased demand even though she charges a high price for the new boat. With high production levels, she reaps economies of scale and benefits from prior learning, thus lowering her average production costs. This combination of high demand, a premium price, and lower costs makes her business very profitable. Her business model sets off a virtuous cycle, enabling her to invest in new generations of outriggers and thus reinforcing her advantage. As long as the Innovator, Woodcutter, and Sailmaker cooperate and minimize any competition for the pie, it will be difficult for others to copy them and claim a share of the value. Thus, several of her erstwhile rivals drop out of boatbuilding completely, perhaps becoming fishermen themselves. No advantage lasts forever, and eventually one of the remaining boatbuilders in the village—we’ll call him Newbie—cracks the code to the Innovator’s design. Once Newbie is able to build a comparable outrigger, the interdependencies between the Innovator’s and Newbie’s business models are very important. The Innovator’s monopoly is broken and, assuming no one else figures out the design secrets, she must learn how to operate in a duopoly. The two business models inevitably touch, so the trick is identifying which combination of choices by the Innovator and Newbie might lead to the best outcome. Figure 3 shows the likely effects when Newbie enters the market and Innovator responds by cutting prices aggressively. The Innovator’s business model is shown on the left side of the figure, Newbie’s is shown on the right, and the overlaps between the models are shown in the dark blue boxes in the center.


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FIGURE 3

Business Model for Boats with Heavy Discounts by Innovator

Different choices lead to different results. The Innovator and Newbie will each benefit from understanding the choices and incentives of the other as well as the consequences of various choices. The Innovator’s response could work if she enjoyed a sustainable cost advantage and could force Newbie out of business, and thus regain her monopoly. On the other hand, if Newbie survives, cutting prices would merely lead to a much less profitable business for both of them. In other words, it would shrink their share of the economic pie, to the benefit of the fishermen. In a second scenario, shown in Figure 4, Newbie again enters the fishing boat market. As in Figure 3, the Innovator’s business model is shown on the left side of the figure, Newbie’s is shown on the right, and the overlaps between the models are shown in the dark blue boxes in the center. Instead of aggressively responding by cutting the price this time, the Innovator could accept that Newbie is here to stay. She could look for ways—perhaps communicating with Newbie through signaling or, absent l egal and ethical considerations, through collusion— to protect the high prices the fishermen have always accepted. In this scenario, the Innovator has to live with reduced market share, but she is likely to maintain a very profitable business.


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FIGURE 4 Business Model for Boats with New Entrant that Maintains High Prices

A third scenario involves a segmentation of the market, which would have implications for both players’ business models. Imagine that there is a growing market for recreational cruise boats, which Newbie is planning to enter with a modified version of the outrigger. The Innovator, knowing Newbie’s plan, could announce that she will focus solely on the fishing boat business. Newbie could take that announcement as a signal that each player can take a different segment of the market and thus avoid a costly head- to-head battle. These examples are not intended to be exhaustive. Rather, they illustrate the range of possibilities that a firm faces and the importance of understanding the choices and motivations of other players in order to play the game on the right terms. They are also relevant to cases of co-opetition, when interdependencies have elements of both cooperation and competition. In our story, the Innovator chose the best Sailmaker in the village to develop the specialized lateen sail for the outrigger. Suppose that the Sailmaker’s business model is driven not only by selling new sails but also by repairing existing sails. Having a large installed base of outriggers fitted with his sails will thus generate business for the Sailmaker over the long term. Fortunately for the Sailmaker, the local fishermen are a superstitious lot and are loath to tempt fate by bringing their sails to anyone else for ser vice. Earlier, we observed that the Sailmaker and Innovator could clash over the division of the value they jointly create. If the Sailmaker focused solely on maximizing value from selling new sails, the partnership might not last long. If he understands the interdependencies between the Innovator’s business and his own, however, he can make choices that strengthen both business models. Figure 5 shows the results of an entry strategy in which the Sailmaker sets a low price for the bundled sail. By doing so, he may benefit from high sales volume, which should lead to recurring, high-margin maintenance contracts. If the price for the bundled sail is high, the Sailmaker may enjoy higher initial profits but be less profitable in the long run because the


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revenue from maintenance contracts will be lower. In this second scenario, the Innovator’s profitability would decrease because she would sell fewer boats. She would not only experience lower sales revenue but also realize fewer economies of scale. FIGURE 5 Entry Strategy for Sailmaker with a Bundled Sail at a Low Price (Choice 1)

Interdependencies: Real-World Examples The interdepedence between the Innovator and the Sailmaker is analogous to the MicrosoftIntel relationship in the 1990s, which provides a real-world example of a state of cooperation and competition. Intel’s substantial investments in generations of microprocessors enabled the company to produce high-quality, proprietary products for which customers were willing to pay a very high price.a Microsoft had a fundamentally different strategy. It profited from the inclusion of a Microsoft operating system (Windows) with every PC sold, but it benefited even more from the sale of high-priced applications, such as Microsoft Office, and upgrades to the large installed base of PC owners. It encouraged the growth of this base by selling its operating system for a relatively low price. Figure 6 shows the economic logic and interdependencies of each firm’s business model. The red arrow shows a negative relationship: higher prices lead to lower sales volumes.

a

Intel made additional choices (not shown in Figure 6) that increased its added value. These included strengthening its position against downstream personal computer (PC) manufacturers by using the “Intel Inside” advertising campaign, using forward integration to increase its bargaining power, and maintaining a short supply of chips and preferential allocation to reward loyal manufacturers. Sourcing choices and aggressive litigation also provided protection against suppliers and would-be imitations and substitutes, respectively.


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FIGURE 6 Economic Logic and Interdependencies of Intel’s and Microsoft’s

Respective Business Models

Source: Reprinted from Harvard Business School, “Competing through Busi ness Models (C): Interdependence, Tactical & Strategic Interaction,” HBS No. 708-476 by Ramon Casadesus-Masanell and Joan Enric Ricart. Copyright © 2008 by the President and Fellows of Harvard College; all rights reserved, based on Ramon Casadesus-Masanell and David B. Yoffie, “Wintel: Cooperation and Conflict,” Management Science 53 (April 2007): 584–598.

The volume of PCs sold depended in part on the prices that Intel set for the microprocessor and on the prices Microsoft set for the operating system. As complements, they formed the so-called Wintel axis, which enabled both companies to create and capture significant value at the expense of IBM and other PC manufacturers. They had a strong incentive to coordinate the release of new-generation processors and operating systems. As long as customers desired the bundled value proposition of Wintel and the two complementors cooperated in their interdependent ecosystem, other firms had trouble weakening Wintel’s hold on the market. b The power of interdependencies is particularly clear when a firm develops a platform that fosters an entire ecosystem of players. A platform is an essential offering, usually a technology, that coordinates suppliers and buyers in the delivery of value to consumers (see Core Reading: Technology Strategy [HBS No. 8127]). A firm with a successful platform must think, by necessity, beyond a zero-sum outcome and find a way to cooperate with other players. The history of Apple provides useful examples of both failure and success on this front. In the 1980s, Apple lost the battle in desktop computing to the Wintel axis largely because it locked out third-party application developers. It chose to develop and market many of its own b

Of course, while having increased their joint added value, both Microsoft and Intel also competed to divide the value and to reduce their dependence on each other.


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software applications, believing it could create and capture this value itself. This choice resulted in a very limited software library for consumers and some subpar offerings because of the lack of competition. In contrast, Microsoft encouraged third-party developers to develop software compatible with its operating system. This strategy led to a far deeper and broader range of software offerings that consumers valued. Microsoft created a platform; Apple did not. Years later, while developing the iPhone, Apple learned the platform lesson. After first trying to block out third-party developers, Apple changed direction and fostered an ecosystem of third-party developers to develop applications (or, more popularly, apps) compatible with iOS, its operating system. Once it created a platform, the power of interdependencies worked in its favor. The popularity of Apple’s hardware and its large installed base attracted the best third-party developers. Consumer demand for third-party apps that worked best, or even exclusively, on Apple’s iOS reinforced demand for the hardware. Meanwhile, all software was sold through Apple’s iStore, enabling the company to capture value for each app sold.

Player Analysis Analysis of interdependencies should help establish the choices and the nature of the game to be played. However, analyzing business models and their interdependencies is not enough— other players may have distinct perspectives or goals that might shape their choices. The purpose of player analysis is to develop insights into the following questions: What is the other player’s perspective on its potential choices? Will this perspective lead it to a particular choice? Michael Porter suggests an integrative framework for player analysis, a s seen in Figure 7. FIGURE 7 Michael Porter’s Integrative Framework for Player Analysis

Source: Reprinted with the permission of The Free Press, a Division of Si mon & Schuster, Inc., from Competitive Strategy: Techniques for Analyzing Industries and Competitors by Michael E. Porter. Copyright © 1980 by The Free Press. All rights reserved.

It is usually possible to learn about a player’s current strategy and capabilities. Doing so can provide a better understanding of which actions the player is most likely to choose. Further, determining what drives that player is more difficult because future goals and assumptions typically cannot be observed (see Supplemental Reading 3.2 on how to gather intelligence on other players). The effort to glean these sorts of insights is worthwhile, however, because they can reveal how the other player sees the game. Earlier, we described how the appearance of Newbie compels the Innovator to think through the interdependencies between them. Figure 8 and Figure 9 show additional insights the Innovator could gain through player analysis. There are two possible scenar ios for Newbie, each with its own implications for how the game might therefore be played.


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FIGURE 8

Scenario 1: Newbie Has Limited Production Capabilities and Resources

Source: Adapted with the permission of The F ree Press, a Division of Simon & Schuster, Inc., from Competitive Strategy: Techniques for Analyzing Industries and Competitors by Michael E. Porter. Copyright © 1980 by The Free Press. All rights reserved.

FIGURE 9

Scenario 2: Newbie Wants to Dominate the Fishing Boat Market

Source: Adapted with the permission of The F ree Press, a Division of Simon & Schuster, Inc., from Competitive Strategy: Techniques for Analyzing Industries and Competitors by Michael E. Porter. Copyright © 1980 by The Free Press. All rights reserved.

In scenario 1 (Figure 8), in which Newbie’s production capabilities are limited, his threat to the Innovator’s market share is modest. The Innovator may be better off keeping her outrigger prices higher than she would if she cut prices in an attempt to force Newbie out of business. In fact, Newbie may price his outriggers close to the price of the Innovator because he does not have the capacity to sell more than a few outriggers per year.


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If Newbie intends to invest more in the production of cruise boats than he does in the fishing market, the Innovator could send a signal that encourages a peaceful, long-term coexistence, allowing Newbie’s entry into fishing boats but maintaining long-term leadership while ceding the cruise boat market. If Newbie has no succession plan, wants to retire rich, and merely needs to provide for his lazy, unmarriageable son, the long-term risk is reduced even further. The Innovator may even see a future acquisition opportunity, provided the village has weak antitrust laws! Her analysis of the other player can help her understand how Newbie views the world and anticipate how he would interpret various ac tions and signals. Of course, if the Innovator’s analysis had shown the player in scenario 2 ( Figure 9)—a well-funded Newbie bent on domination of the fishing market—the likely actions change entirely. Protecting the Innovator’s fat profits and comfortable position as market leader becomes much more difficult. In that case, the Innovator would look hard at the quantitative consequences of different choices and try to choose actions that optimize her economic payoffs. Player Analysis: Real-World Limitations to Rational Thinking

Before we move into game theory, it is useful to consider why game theory may yield predictions that differ from the reality of a competitive game, and hence why player analysis matters. Game theory solutions are predicated on rational, profit-maximizing decisions by the players. In reality, managers may not make optimal decisions. Player analysis provides insight into a firm’s view of the game and its options. It may help reveal organizational assumptions that can lead to suboptimal outcomes. A firm may have deeply held beliefs that will prevail in decision making, regardless of new information or the actions of other players. It could also have nonfinancial motives. These tendencies and beliefs will determine how the firm plays the game. The concept of bounded rationality , as its name suggests, states that rational decision making has limits. Bounded rationality has different causes. The decision makers in a firm may make an error of heuristics, using a poorly chosen rule of thumb to interpret a situation incorrectly. This is especially common when decision makers generalize on the basis of a few seemingly similar situations from the past. They could also suffer from overconfidence. Managers can overestimate their firm’s own added value, capabilities, and probability of success, while underestimating other players, if they seek information that confirms their beliefs rather than honestly evaluating counterarguments or contradictory evidence. The limits of rational behavior can also be observed in the endowment effect , which causes managers to value something they already own more than what they d o not own. For example, a firm could focus too much on avoiding market share loss, which leads it to behave more aggressively than is rational. These examples of bounded rationality are still attempts at rational decision making, but individuals may also ignore rational analysis altogether, often because emotions come into play. For example, a decision maker’s judgment could be clouded by a desire to justify past actions. Perhaps he or she has an ego-driven need to save face or is unwilling to accept a sunk cost, leading the firm to “throw good money after bad.” 4 In more extreme cases, a decision maker who feels slighted or wronged may act out of spite, embracing a poor outcome to punish another player. In Video 1 from the television crime drama Numb3rs, we see how revenge and other powerful emotions can lead people to act against their self-interests. Similar behavior may play out between firms when decision makers allow frustration or anger to trump rational thinking. VIDEO 1

Game Theory in the Television Show Numb3rs

Scan this QR code, click the i con, or use this link to access the video: youtu.be/BfE4ZL08twA


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Player analysis can help us assess the probability that a player will make a suboptimal choice. How has the firm behaved in the past? What organizational assumptions or beliefs will shape perceptions and decisions? Have patterns of choices evolved because of culture or influential personalities within the organization? Answering these questions in advance will boost the robustness and predictive power of game-theory analysis and help us to determine what game will be played—or whether the other player even recognizes that he or she is playing the game.

Game Theory Modern game theory was developed in the late 1940s, but it has become a widely used tool for business strategy only in the past 20 years. Many of the ideas—such as dominant strategies, the prisoner’s dilemma, and Nash equilibrium—are now firmly established in the lexicon of business. All the concepts and terminology may make game theory seem overwhelming. However, it is important not to lose sight of its primary purpose: determining how various players value and thus make choices. Game theory involves three basic elements: players, actions, and payoffs. We have gained some clarity on the first two through our discussion of interdependencies, which illuminate key choices, and of player analysis, which reveals how those choices are likely to be seen. Together, those two tools tell us what game is being played. We then must examine the economic results—or payoffs—of possible outcomes (or combinations of players’ choices) and what they mean for each player’s actual choice. Game theory helps us think through the following questions:

For every outcome, what is the payoff for each player? What is each player’s best choice give n what the other player does? Every combination of choices results in a different economic payoff for the players. c The key to game theory is to think forward, reason back. We think forward by estimating all potential outcomes. Then we reason back from each player’s perspective and reject suboptimal choices. This should leave us with the game solution, the outcome in which each player has made the best possible choice given choices by the other player. Once the players have reached this outcome, neither has any incentive to cha nge its choice unilaterally—the solution is one of equilibrium (or, more precisely, Nash equilibriumd). There are two basic ways to represent a game: Matrix form (also known as normal form or strategic form) displays the game in a table, with each player’s choices shown along the rows or c olumns. The cells of the table show the combinations of the choices, each of which is a possible outcome. Game tree form (also known as extensive form) represents the game as a series of possible decisions that branch out into the full set of potential outcomes.

The payoffs for each player are shown in the cells of the matrix or at the end of the game tree. By convention, the first number is the payoff for the row player (in matrix form) or for the c

This may mean the available profits or the net present value of a particular choice. The metric for the payoff depends on the available data and the level of a ccuracy required for meaningful analysis. In the remainder of this section, we assume that the hypothetical payoff figures shown represent the annual profit for each player.

d

Nash equilibrium is named for the mathematician John F. Nash, who won the Nobel Prize for economics in 1994. Nash proved the existence of equilibria (possibly in mixed strategies) for non-cooperative games with a finite number of players, where each player has finitely pure strategies at her disposal.


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player making the first choice (in tree form). Figure 10 shows how this works, with Player A’s payoffs in orange. FIGURE 10 Player A’s Payoffs (Shown in Orange) in Matrix Form

In general, the matrix form is useful for games in which players make decisions simultaneously, meaning that neither player knows the other’s ch oice before making his or her own. The game tree form is more useful when players make decisions sequentially. In the game tree seen in Figure 11, for example, Player B knows Player A’s choice before making its own decision. Again, Player A’s payoffs are in orange. For the remainder of this reading, we will alternate between the matrix and tree forms, depending on which is more intuitively useful for the example. FIGURE 11 Player A’s Payoffs (Shown in Orange) in Game Tree Form

Let us begin with a simple decision about market entry. To think forward and reason back, we start by identifying the full set of possible outcomes and determining whether either player has an obvious strategy—a choice that makes sense no matter what the other player does (the formal game theory term for this is dominant strategy ). Earlier, we discussed how the world in the fishing village would look with the emergence of Newbie. Let us assume that, through interdependencies and player analysis, we have determined that Newbie will enter the fishing boat market and is willing to price slightly below the Innovator’s price. Figure 12 shows the possible choices and payoffs for the Innovator and Newbie in matrix form. What are the payoffs for Newbie? What are the payoffs if the Innovator makes room in the market for him (accommodates), and how does this change if the Innovator reacts aggressively (fights)?


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FIGURE 12 Choices and Payoffs for Newbie and Innovator in Matrix Form

In this scenario, each player has an obvious (dominant) strategy: a rational choice with a better payoff no matter what the other player chooses: •

The Innovator should never discount, whether Newbie enters the market or not.

•

Newbie should always enter, whether the Innovator discounts her price or not.

The solution to this game is straightforward: Newbie will enter the fishing boat market, and the Innovator will accommodate him by keeping prices high. If the Innovator goes through this analysis, she will conclude that Newbie will enter. If Newbie does the same analysis, he will see that the Innovator will never discount. Here, each player has a clear choice. What happens when one player’s choice is not clear and depends on what the other player chooses? Suppose now that Newbie has entered the fishing boat market and has taken some share from the Innovator, as we saw in the game above. Both firms now focus on export sales to the islands, which have begun trading with our village and where a large market of fishermen awaits. Our firms must decide whether to invest in advertising on the islands. As the market leader, the Innovator would benefit from gradual word-of-mouth sales and does not need to rely on advertising, which is very costly. Because Newbie is relatively new, he would benefit from aggressive advertising to raise awareness in the new market. Figure 13 shows the possible choices and payoffs. This time we use the game tree form because the Innovator will wait for Newbie to take action before doing anything her self. FIGURE 13 Possible Choices and Payoffs for Newbie and Innovator’s Decision to

Advertise


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If Newbie looks forward and reasons backward, we see that he has a simple strategy, while the Innovator’s choice depends on Newbie’s: •

The Innovator prefers that no one advertises, but should advertise if Newbie does

•

Newbie should advertise

The solution to this game lies in ruling out the scenario that Newbie’s obvious strategy has made moot. Regardless of whether the Innovator prefers to advertise, Newbie will advertise if he recognizes the game payoffs. We can eliminate the scenario in which no one advertises. Newbie will advertise, leaving the Innovator with one choice. Let us now look at a situation where no one has a clear strategy, and each player’s choice depends on the choice of the other. Imagine that the Innovator and Newbie now consider two potential new market segments: holiday cruise boats and trading boats. Each firm has resources to build manufacturing facilities for just one market, and neither is able to wait and see what factory the other builds. In other words, they must make their decisions simultaneously. Figure 14 shows the possible choices and payoffs for the Innovator and Newbie. FIGURE 14 Possible Choices and Payoffs for the Types of Boats that Newbie and

Innovator Manufacture

We see that the best choice for each player depends on the other player’s choice. There are two solutions (or two Nash equilibria). e As long as they pursue different market segments, each firm (or player) is better off. Once they have each landed on different market segments, then they have reached one of the two equilibria and have no reason to change their choices. f Even if the Innovator and Newbie refuse to speak to each other, they have very good reason to reach one of the two solutions. In this situation, a credible signal by one player regarding its choice—in advance of the actual construction of the factory—should lead the other player to make the corresponding, rational choice. The examples thus far have featured one-time decisions (known as single-play games). What does game theory tell us about the difference between single-play games and ongoing, repeat-play games? Suppose that the fishing boat market in the village and the islands has matured, and only a few more sales can be made. The Innovator and Newbie now have reason to discount the fishing boat in order to claim the few selling opportunities available, and they must announce their prices before the selling season starts. Figure 15 shows how a one-time game would be played.

e

There is also a mixed solution, where players randomize their choices. We ignore this possibility because randomized choice is not plausible in this case.

f

Strictly speaking, there is one more probabilistic or mixed s olution, but this is not relevant for management.


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FIGURE 15

Possible Choices and Payoffs if Newbie or Innovator Offers a Discount

Each player has an obvious (or dominant) strategy of discounting. Both players will heavily discount and barely break even. What is notable about this game is that there is a much better joint outcome if neither player discounts, but this outcome requires them to ignore their dominant strategy. This situation is commonly known as the prisoner’s dilemma (also known as Pareto suboptimal). In the classic prisoner’s dilemma, two prisoners are given the choice to testify against the other (analogous to discounting in our example) or to remain silent. If one testifies and the other remains silent, the one who has testified can go free while the other is imprisoned for many years. The best outcome would be for both to remain silent, in which case they face only a short prison term. However, they cannot coordinate their decisions, and they do not trust each other. Thus the rational, dominant strategy for each is to testify, resulting in a prison term for both because each prisoner must weigh the probability that the other will testify against him. Given the payoffs, the impulse to betray the other prisoner is powerful. In the Innovator’s and Newbie’s version of this situation, there is no escaping the prisoner’s dilemma if they believe this is a one-time game and do not collude. However, suppose they recognize that they are playing a repeated game: Every year, old boats are retired and a few new fishermen join the industry. Each player will set fishing boat prices year after year. The choice made in each game is itself a signal for the next year’s game. In that case, what is the best strategy? Robert Axelrod, best known for his work on cooperation in the realm of public policy, simulated tournaments to compare the success of different strategies for repeated plays of the prisoner’s dilemma. He found that a simple tit-for-tat strategy is the most robust approach in repeat-play games. 5 A player using a tit-for-tat strategy responds to the other player’s prior choice by cooperating with cooperative plays and retaliating against uncooperative plays. For example, Newbie would start with a high price, which he would maintain as long as the Innovator cooperated and kept a high price. If the Innovator cheated by discounting, Newbie would also discount, until the Innovator raised her price again and Newbie followed suit. g With any cooperative strategy, particularly where pricing is concerned, it is critical to remember that collusion is illegal. Competitors can avoid price discounting, but must pay attention to how they do so. Firms need to be careful that signals and tactics intended for cooperation—in the game-theory sense of the word—do not cross the line into collusion. In addition to repeated games, other factors may encourage players to cooperate, leading to more efficient outcomes. Developing the right type of reputation, for instance, can give a firm g

Note that this outcome applies if the repeated game is infinite, or at least it is perceived to have an indefinite duration. A repeated game that is known to be finite by the players will still result in a prisoner’s dilemma.


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a strategic advantage. A firm could deliberately develop a reputation for aggressive or irrational retaliation by overreacting under certain circumstances or for taking several turns in a repeated game. The fear of inciting more such behavior can lead other players to engage in more cooperative behavior. Similarly, the right contract may be a valuable deterrent to uncooperative behavior. For example, if two competitors are fighting for market share with a buyer, one may enter a contract that requires it to match any competitor’s price. Such an obligation makes it clear that price discounting will destroy profits for everyone. Such terms, if publicly disclosed, become a useful deterrent. In the following section, we expand on this theme and explore how a firm can improve its position in the game by changing the added values of the participants.

2.3 Playing to Win (or Win-Win)

Changing Added Value: Commitments and Capabilities The game before us need not be the only game we play. Sometimes we can change the payoffs or, as discussed below, even the scope of the game. One way to do this is to increase or protect our firm’s added value. Pankaj Ghemawat has discussed doing so through commitments and capabilities.6 A commitment is a major investment that is impossible or costly to reverse. It might be the acquisition of another company, a significant capacity expansion, or a new-product launch. A player makes a commitment to stake out a position that is credible to other players in the game, who need to believe that the commitment could lead to a particular move that is irreversible. For example, if the Innovator builds a new factory for boat production or acquires large tracts of forest with the trees she needs, she sends a strong signal about her intent and her power. Commitment can lead to deterrence and increased bargaining power . If Newbie sees the new factory, he may see the Innovator’s intention to protect her business by reducing his added value. He will worry about the Innovator’s production cost advantage and ability to drop prices to levels that are unprofitable for him. The payoffs of this game may be different from those of the previous game, and he may fear that the Innovator will not accommodate his entry. Likewise, if the Woodcutter sees that the Innovator could backward-integrate into timber production, he will think twice about trying to capture more value by raising his price s. The Innovator need never drop her prices or backward-integrate, but her commitment makes it clear that she could. She has thus changed everyone’s added values. For example, in the 1970s, DuPont had a cost advantage in the production of titanium dioxide but faced the risk of imitation. In a show of commitment, it preemptively built a large new plant. Its capacity deterred anyone else from expanding, leaving DuPont as the sole global producer in the subsequent decades.7 The 1964 Stanley Kubrick film Dr. Strangelove or: How I Learned to Stop Worrying and Love the Bomb (see Video 2) captures the power of commitment to create a deterrence and increase bargaining power in scenarios of nuclear war, where mutually assured destruction keeps everyone in check. An unauthorized attack on the Soviet Union threatens to trigger its doomsday device, which is set to detonate in the event of a nuclear attack and render the earth uninhabitable. The Soviets had built the device in response to reports that the Americans were doing the same, attempting to maintain a credible commitment as a deterrent. It triggers automatically and cannot be disarmed, making it truly irreversible—an attribute that Dr.


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Strangelove correctly notes is “essential” to its function as a deterrent. Of course, to serve its function, a commitment must be known by the other players. Unfortunately, in the movie, the Soviets’ remarkable—or insane—level of commitment had not yet been communicated to the Americans. As the character Dr. Strangelove remarks, “The whole point of the doomsday machine is lost if you keep it a secret!” VIDEO 2 Mutually Assured Destruction in the Film Dr. Strangelove or: How I Learned to Stop Worrying and Love the Bomb Scan this QR code, click the icon, or use this link to access the video: youtu.be/2yfXgu37iyI

A more lighthearted example of commitment can be seen in the UK game show Golden Balls (see Video 3). At the end of the show, the two contestants have a large sum of money, which they can choose to “split” or “steal.” If both choose to split, then they will divide the winnings. If both choose to steal, each walks away with nothing. The catch, of course, is that if only one player chooses to steal, he or she takes all the spoils. In the typical game, each contestant attempts to convince the other that he or she is trustworthy and will choose to split. In the game depicted in Video 3, one contestant adopts an unusual tactic. One of the contestants, Nick, makes a very clear commitment to what is an apparently irreversible position. Unlike the ill-fated Soviets in Dr. Strangelove, however, he communicates this commitment both effectively (and entertainingly), thereby forcing the other player to do exactly what he wants. VIDEO 3 An Example of Commitment in the Game Show Golden Balls Scan this QR code, click the icon, or use this link to access the video: youtu.be/S0qjK3TWZE8

A player can also increase or protect the added value of her or his product—and potentially lower that of other players—by investing in capabilities that create competitive advantage, such as superior production capabilities, organizational processes, or institutional knowledge. Both the Innovator and Newbie know how to build outriggers because there are prerequisite capabilities to do so. However, the Innovator’s experience may create capability advantages— perhaps faster time to market, lower costs, or better quality. The US automobile industry in the 1980s provides a compelling real-world example. Honda and Toyota sold vehicles that were comparable in price and positioning to those of General Motors, Ford, and Chrysler— the Big Three automakers in Detroit. Yet the Japanese manufacturers could introduce new models in half the time and with half the engineering resources required by their US competitors. This gave them many more options to bring cars to market, which they could produce at lower cost and with better quality. 8 By changing added values through commitments and capabilities, a player can materially change the payoffs for itself and for others. This in turn may change the scope of the game, perhaps encouraging other players to make different choices or engage in a different game altogether.

Changing the Scope of the Game Increasing your added value—or decreasing the added value of others—is not the only way to change the game. Savvy players may be able to change the scope of the game—or perceptions of the scope of the game—to their advantage. There are many ways to do this, but here we will provide an overview of some of the basic tactics. It is sometimes advantageous, particularly for the weaker player, to change altogether the game that is being played. If an honest assessment of your added value and interdependencies suggests that the game could go very badly for you, there may be ways to adjust the game’s 8131 | Core Reading: COMPETITIVE AND COOPERATIVE DYNAMICS

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scope. One can choose a focused game that does not lead to an immediate response from the other player. In game theory terms, this option entails choosing a game where, from the other player’s perspective, the interdependencies are modest and the payoffs are immaterial, no matter what choices are made. In the parlance of competitive strategy, this option, which involves selecting a market that is unthreatening enough or niche enough that the other player cannot or will not react, was termed Blue Ocean Strategy by W. Chan Kim and Renée Maubourgne.9 If the Innovator has committed to the fishing boat market by building a large factory, as described earlier, then Newbie may no longer wish to enter directly. The payoffs for fighting off Newbie may be acceptable for Innovator and very costly to Newbie. However, if Newbie were to announce that he was focused on a niche—perhaps highly customized fishing boats or recreational outriggers—his entry may no longer be worth a response from the Innovator. Newbie has shifted the game to an arena that does not interest the Innovator. Indeed, the Innovator may have no way to respond because she has committed to a factory that presumably produces relatively standardized fishing boats at low cost. In that sense, Newbie has used the Innovator’s own strengths against her—a tactic many refer to as Judo Strategy .10 In the video game console industry, a focused approach and Judo Strategy enabled an alsoran to establish itself. In the 1980s, Nintendo was the juggernaut. The success of its 8-bit console had left rivals, including Atari and Sega, far behind. It had created a powerful virtuous cycle with a large installed base of consoles and tight control of its complementors, the video game developers, from whom it captured a large share of every game cartridge sold. In 1989, Sega introduced the Genesis, its 16-bit console, to the US market, but did so very carefully. It knew that Nintendo needed to protect its 8-bit console business model. Rather than compete directly with Nintendo’s 8-bit system, Sega priced the Genesis much higher. Nintendo had a 16-bit system in the wings—this was not a matter of innovation. However, the Genesis did not directly threaten Nintendo’s 8-bit business; the strength of its model and complementors discouraged an immediate response. In fact, Nintendo milked its 8-bit business for two more years before it finally entered the 16-bit market. Arguably, this was a win-win decision beca use both firms benefited during this period, whereas prices and profits fell quickly once Nintendo rolled out its 16-bit system. By focusing on a different market and taking advantage of Nintendo’s existing strengths, Sega had executed a Judo Strategy that gave it enough time to establish a strong market position. 11

Changing the Boundaries: Linking Games No game is played wholly in isolation. Beliefs about how the outcome of one game affects another can be very powerful, and such beliefs can change the games themselves. According to Brandenburger and Nalebuff, two games are linked when they are perceived to be linked. The boundaries of strategic interactions change when games are believed to be connected (or not connected), and firms can try to manage these perceptions to their advantage. An elementary example of this is the chronological linkage of games—the perception that the outcome of today’s game will shape tomorrow’s game. The tit-for-tat strategy described earlier clearly depends on this linkage. If Newbie and the Innovator both believe that next year’s game will be shaped by this year’s game, then the boundaries of the current game have been expanded and the prisoner’s dilemma is not inevitable. Establishing the right precedents and reputation can be useful in managing the boundaries of games and, in this case, creating a win-win situation. Game linkages can also work non-cooperatively. Suppose the Innovator and Newbie have developed strong markets in trading vessels and cruise boats, respectively. If the Innovator were to venture into the cruise boat market, Newbie’s best move may not be to react directly.


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Instead, Newbie could choose to attack the Innovator’s trading vessels business by selling his own trading boats at a steep discount. In this way, Newbie protects his own profitable cruise boat business while eroding the profits in an area where he stands to lose nothing. By expanding the boundaries beyond the battle for cruise boats, he may persuade the Innovator to back off. Note that it may also be advantageous to delink games to encourage the other player to engage in one game while ignoring another. In the early 2000s, Nike used this to its advantage against Adidas in the European market. Nike’s interest was in the global athletic footwear market. Because Nike knew that Adidas was highly protective of its European business, it deliberately bid up the price for celebrity endorsements there. Adidas diverted cash to keep up with Nike in Europe, which left it without the resources to compete elsewhere; this in turn allowed Nike to be a largely uncontested leader in most other markets. In essence, Nike had executed a diversionary tactic by drawing the boundaries narrowly, causing Adidas to overlook the much bigger stakes. 12

2.4 Conclusion In this reading, we have seen the competitive and cooperative dynamics that can emerge in the creation and capture of value. Strategic interactions between firms include more than competitive rivalry; they encompass suppliers, customers, and complementors. In addition, a strategic interaction between firms is often simultaneously competitive and cooperative. Determining what game is being played requires an analysis of how business models affect each other and the perceptions, motivations, and likely choices of each firm. Game theory then helps us quantify the results of different choices and identify the optimal outcome for the players. Of course, this reading provides only a brief introduction to the subject of game theory. The key lesson is that we must put ourselves in the shoes of the other player. We must analyze his or her problems as if they were our own and recognize that he or she is also thinking strategically. By understanding the other player’s payoffs for different choices, we can identify his or her most likely choice and thus determine our best choice.

3 SUPPLEMENTAL READING 3.1 Reaction Curves and Price Leadership In the examples covered in this reading, we have presented players’ decisions as binary: enter or stay out, fishing boats or cruise boats, discount or maintain the price, and so on. In reality, a player’s options may be more complex. For example, a price discount might range from modest to extreme, or spending on an advertising campaign may be more or less aggressive. There may be many combinations of choices and payoffs. As we will demonstrate, however, such a game can still be analyzed the same way. Even when there are many incremental choices, game theory points us toward an outcome in which neither player can unilaterally improve on its payoff—known as the equilibrium outcome. In the example below, we demonstrate how to construct a matrix comprising many potential choice combinations. We


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will then introduce two concepts that help us analyze the game: reaction curves and price leadership. In our example, we keep the maritime setting but move to a more modern situation: container shipping. In this Darden Business Publishing case, Lesser Antilles Lines (LAL) is one of two firms competing to ship containers to San Huberto, a small Caribbean island. In a bid to gain market share against the incumbent, Kronos Lines (KL), LAL has cut its pricing. Because the firms are serving a small island, better prices have had no bearing on underlying demand—primary demand for shipping services remains unchanged. Instead, both players find themselves engaged in a vicious price war, chasing market share at the expense of profitability. Tired of losing money for the past year, LAL analyzes the market. This analysis yields some important insights: •

•

•

•

Customers prefer to split their business between two players. At equal prices, LAL can expect only a 40% market share because of customer loyalty to KL. A price difference of $100 equals a 10% share loss for the more expensive firm. In addition to elucidating market demand, LAL’s research reveals that LAL’s variable cost per container is $841, slightly lower than KL’s c osts at $883 per container. Taken together with estimated market demand of 3,900 containers (or trailer equivalent units [TEUs]) per year, we can calculate market share and contribution margins for each player using the following formulas: 

Market share for LAL = 40% + (KL price − LAL price)/1,000



Market share for KL = 60% + (LAL price − KL price)/1,000



Contribution for LAL = 3,900 TEUs × market share for LAL × (LAL price − $841)



Contribution for KL = 3,900 TEUs × market share for KL × (KL price − $883)

With a range of pricing choices for both KL and LAL, we can construct the game matrix shown in Interactive Illustration 2. Using this matrix, KL and LAL each choose among 12 prices, which range from $800 to $1,900. KL’s prices are in the first column; LAL’s prices are in the bottom row. For every price combination in the matrix, the firms’ respective payoffs (in thousands) are shown. You decide which player to be—KL or LAL—and whether to set a price first. If you choose to set the price, click on one of the buttons along the horizontal (LAL) or vertical (KL) axis, then click Run. After KL or LAL sets the initial price, the second player reacts to the first player’s move by setting its price in order to maximize its payoff based on the price that the first firm set. From this point, the firms take turns changing their prices in order to maximize their payoffs. The game ends when both firms choose to stay at their current price.


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INTERACTIVE ILLUSTRATION 2 Pricing Matrix and Reaction Curves for KL and LAL

Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2unHzxN

Source: Phillip E. Pfei ffer and James V. Gelly, “Lesser Antilles Lines: The

Island of San Humberto (A),” University of Virginia, Darden Business Publishing No. UVA-QA-0355. Copyright © 1991 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved.

After three iterations of the game, the reaction curves for KL and LAL are displayed. These curves show each firm’s optimal choice for any choice the other player makes. In other words, they show what KL’s profit-maximizing price is for any price that LAL sets, and vice versa. Suppose, for instance, that both players begin by offering the unsustainable price of $800 per container. From this point, either player could change its price unilaterally and improve the outcome—KL from losing $194 per container, and LAL from losing $64 per container. If the game is played repeatedly, the players could follow this sequence: •

•

•

LAL sees that, at an $800 KL price, its best move is a $1,000 price, as indicated by its reaction curve. At a $1,000 LAL price, KL in turn sees that its best move is to increase to a $1,200 price, as shown on its own reaction curve. At a $1,200 KL price, LAL’s best move is to match the $1,200 price.

From an equilibrium price, neither player can improve its payoff unilaterally. Outside this equilibrium, at least one player will feel pressure to change because it will have the opportunity to improve its payoff. Nonetheless, this equilibrium may not be the best place for the players to be. Other outcomes are better for both players when both choose to increase their prices. The problem is that both players must choose to do so. Once the players have arrived at equilibrium, neither one can do better unilaterally. LAL and KL are in a situation in which it is difficult to move away from equilibrium, called a sticky situation. However, the equilibrium can change if our starting assumptions about firm behavior change. The equilibrium in Interactive Illustration 2 assumes that each player will select the optimal price based on the other player’s choice. Let us suppose instead that LAL is willing to consider trying different prices and that KL will select a pric e based on the price that LAL sets.


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If LAL understands the game, it will select the price on KL’s reaction curve that gives it the highest payoff. This is where KL and LAL both price at $1,500 per container, giving the latter a payoff of $1,028—its best outcome on the KL curve. In this scenario, LAL demonstrates price leadership, proactively setting a price that will lead to a response from KL. If LAL moves from the equilibrium above to a $1,500 price, however, it may see a temporary dip in contribution margin. Price leadership means it chooses to hold this $1,500 price as KL recognizes its action and moves to the best outcome on its reaction curve. If KL is the price leader, it could increase its price to $1,700 per container. LAL would respond by moving to the $1,500 price on its reaction curve. This response gives KL $1,274, which is its best payoff on LAL’s reaction curve. In our game, each player is better off allowing the other to be the price leader and reacting as the follower. Which of the two price-leadership equilibria the firms arrive at depends not only on which player has the capability and credibility to act as the price leader but also on whether the other firm recognizes that it is best to follow.

3.2 Gathering Intelligence Conducting player analysis typically requires gathering information from a variety of sources. Many questions must be considered to determine how the other player may see and play the game. What is the other player’s stated strategy? How might the actual strategy differ under different circumstances? What effect do industry trends have? What are managers’ beliefs and assumptions, and what biases may shape their decisions? While no one source will provide complete intelligence for a game, it is possible to synthesize multiple sources to develop a good understanding of the other player’s perspective on the game as well as her or his economic payoffs for different outcomes. Sources of player intelligence fall into one of two categories: what the players say about themselves , and what others say about them. 13 What players say about themselves can be revealing. History can also be instructive: Past decisions on matters such as products, pricing, advertising, and/or capacity may provide clues about the actions a firm is likely to consider. The sources for such information can be broken down based on the audience: •

•

•

•

Investor communications encompass annual reports, required filings (e.g., 10Ks in the United States), and shareholder meetings. These can provide insight into a firm’s strategy and capabilities and sometimes reveal the company’s perspective on its ne arand long-term prospects and risks. In addition, the financial data in these documents may be a useful way to estimate the company’s payoffs under different game scenarios. Government materials range from filings required by a regulator (e.g., the Secur ities and Exchange Commission [SEC] or other regulatory agencies) to records for court proceedings or testimonials to the government. These may be particularly helpful in strategic interactions that could involve decisions from the public sector. Trade materials include patent records, technical paper s, licenses, and manuals. These may be useful for understanding potential company actions in the areas of product development or intellectual property. Public communication includes advertising, promotional materials, press releases, and management speeches. These can shed light on historical patterns of behavior and can indicate the types of commitments and positioning that the company wants the public to know.


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A company may not have a complete picture of its own situation, and most companies are unwilling to reveal the full extent of their plans. What others say about a player can help the strategist develop a more holistic perspective. Again, these can be categorized according to the intended audience: •

•

•

•

Investor materials include analyst reports and industry studies by investment banks and consultancies. Firms with publicly traded debt must also report to credit agencies. These materials often include projections for industry growth and company financials, which can be immensely useful for evaluating the ec onomic implications of different scenarios. They also shed light on investor expectations and the pressures facing managers, which can help a strategist evaluate how the other player is evaluating short- and long-term actions. Government materials include lawsuits or regulator reports. Again, these are most relevant in games where the public sector may influence actions and outcomes. Trade sources include industry studies, trade associations, and trade publications. They may provide information on industry trends, competitive developments, and a particular player’s prospects. They may also speculate on or report plans that a company has not yet discussed publicly. Also in this category are suppliers and customers: They can provide vital insight on a company’s trends a nd intentions. Note, however, that working with such sources demands clear ethical standard s, which will be discussed below. Public materials may include books, business press, and even case studies (e.g., Harvard Business School studies). These may reveal past beha vior, managers’ beliefs and biases, and potential actions.

Most of the sources listed here are publicly available secondary sources and thus are fair game for a strategist who is analyzing another player. However, the gathering of intelligence can lead to actions that are ethically problematic or at least ambiguous. Any additional insight that the strategist gains can provide a competitive edge, and there are many ways to cross the line. Some actions are clearly unethical and usually illegal, such as outright theft, covert surveillance, directly gathering confidential information (e.g., interviewing company employees), or attempts to influence the judgment of those with information (e.g., through bribery). Practitioners of gathering intelligence state that their ethical challenges come most frequently in primary research with customers, suppliers, or even former employees of a company. Interview subjects may share too much, either by design or by mistake, and great care is required to avoid an ethical breach. The most common temptation lies in misrepresentation of the identity or the intent of the one gathering intelligence. 14 Misleading interviewees to encourage them to divulge more information is problematic. Ethical breaches of this sort include pretending to be a student or academic researcher, for example. Best practices by conscientious practitioners include instructing an interview subject directly not to review confidential information, as well as a refusal to use information that should not have been shared. Gathering the intelligence is necessary, but it is not sufficient. The strategist will need to interpret what she sees in order to anticipate competitive or cooperative dynamics. This effort will inform the evaluation of a strategic interaction and the analysis of possible games. A robust, effective plan for strategic interaction includes contingencies—accounting for the possibility that the intelligence is incomplete or that the other player acts contrary to the evidence.


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4 KEY TERMS added value The size of the pie when the

game tree form A representation of a

player is in the game minus the size of the pie when it is out of the game.

game among various players as a series of possible decisions that branch out into the full set of potential outcomes. Also known as extensive form.

Blue Ocean Strategy

A strategy in

which a firm creates a marketing space that players cannot or will not attempt to occupy. bounded rationality The limits of actors’

ability to be perfectly rational in making decisions. capabilities The know-how to produce a

increased bargaining power

A situation in which one player in an exchange can increase the value it captures from other players. interdependencies How the choices that

good or service reliably.

one player makes influences the choices and payoffs for other players.

commitments Major investments that are

Judo Strategy A situation in which a

costly to reverse. competitive interactions Interactions

in which one firm’s business model causes another firm to create or capture less value. complementors Companies in one

industry whose products or services increase the value of products or services of companies in another industry. cooperative interactions Strategic

interactions among companies that help make the pie of value bigger for a product or service. co-opetition A state of simultaneous

cooperation and competition between firms. deterrence A situation in which one

company’s actions influence another company to delay or decide not to do something it otherwise would have done. dominant strategy A choice that makes

weaker company does not compete directly with a dominant firm and uses the strengths of the dominant firm against it. matrix form A representation of a game in

a table, with each player’s choices shown along the rows or columns. The cells of the table show the combinations of the choices, each of which is a possible outcome. Also known as normal form and strategic form. normal form See matrix form. player analysis An analysis of how each

player in a game sees its world and its choices. price leadership A situation in which

one company in an industry sets the prevailing price, and other competitors follow this company’s lead when they set their prices. prisoner’s dilemma A situation in a

game theory in which neither player can unilaterally improve on its payoff.

game in which the players have a much better joint outcome if no player defects, but in which each player has a strong incentive to defect because it cannot communicate with other players.

extensive form See game tree form.

reaction curve The payoff curve that

game theory A branch of economics that

describes a company’s optimal choice for any given choice by other players.

sense no matter what the other player does. equilibrium outcome A situation in

studies the economic outcomes of various scenarios and how those outcomes affect each player’s likely choices.

repeat-play games Games in which each

player makes ongoing decisions.


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single-play games Games in which each

value capture Interactions by players that

player has to make a one-time decision.

change the division of the pie.

strategic form See matrix form.

value creation Interactions by players

strategic interaction Situations in which

that make the pie bigger.

the business model of one firm affects the performance of other firms. tit-for-tat strategy A strategy in which a

player responds to another player’s prior choice by cooperating with cooperative plays and retaliating against uncooperative plays.

5 FOR FURTHER READING Casadesus-Masanell, Ramon, and Joan E. Ricart. “How to Design a Winning Business Model.” Harvard Business Review 89 (January–February 2011): 100–108. Ferreira, Nelson, Jayanti Kar, and Lenos Trigeorgis. “Option Games: The Key to Competing in Capital-Intensive Industries.” Harvard Business Review 87 (March 2009): 101–107. Ghemawat, Pankaj, and Patricio Del Sol. “Commitment versus Flexibility?” California Management Review 40 (Summer 1998): 26–42. Lichtendahl, Kenneth C., and Samu el E. Bodily. “Airbus and Boeing: Superjumbo Decisions.” Darden Business Publishing Case UV1312 (Charlottesville, VA: Darden Business Publishing, 2008).


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6

ENDNOTES

1 Ramon Casadesus-Masanell, “A Note on Strategic Interaction,” HBS No. 714-417 (Boston: Harvard Business School Publishing, 2013). 2 Adam Brandenburger and Barry J. Nalebuff, “The Right Game: Use Game Theory to Shape Strategy,” Harvard Business Review 74 (July–August 1995): 57–71. 3 Adam M. Brandenburger and Barry J. Nalebuff, Co-Opetition (New York: Currency Doubleday, 1996), 72– 76. 4 Peter J. Coughlan, Debbie Freier, and Kaiho Patrick Lee, “Competitor Analysis: Anticipating Competitive Actions,” HBS No. 701-120 (Boston: Harvard Business School Publishing, 2001). 5 Robert Axelrod, The Evolution of Cooperation (New York: Basic Books, 1984). 6 Pankaj Ghemawat, Commitment (New York: Free Press, 1991). 7 Pankaj Ghemawat, “Du Pont’s Titanium Dioxide Business (A),” HBS No. 390-112 (Boston: Harvard Business School Publishing, 1989). 8 Pankaj Ghemawat and Gary P. Pisano, “Sustaining Superior Performance: Commitments and Capabilities,” HBS No. 798-008 (Boston: Harvard Business School Publishing, 1997). 9 W. Chan Kim and Renée Mauborgne, “Blue Ocean Strategy,” Harvard Business Review 82 (October 2004): 76–84. 10 David B. Yoffie and Mary Kwak, Judo Strategy: Turning Your Competitors’ Strength to Your Advantage (Boston: Harvard Business School Press, 2001). 11 Adam M. Brandenburger and Barry J. Nalebuff, Co-Opetition (New York: Currency Doubleday, 1996), 237– 242. 12 Ian C. MacMillan, Alexander B. van Putten, and Rita Gunther McGrath, “Global Gamesmanship,”Harvard Business Review 81 (May 2003): 62–71. 13 Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: The Free Press, 1998), pp. 368–382. 14 Linda Klebe Trevino and Gary R. Weaver, “Ethical Issues in Competitive Intelligence Practice: Consensus, Conflicts, and Challenges,” Competitive Intelligence Review 8 (Spring 1997): 61–72.


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7 INDEX added value, commitments and capabilities with, 23–24 added value, definition of, 7, 31 added value, overconfidence about, 17 added value, overview of, 7–8 Adidas, 26 advertising, 20–21, 26, 29 airline industry example, 6 allocentric viewpoint, 9 American Airlines, 6 Apple, 15 athletic footwear industry example, 26 automobile industry example, 24 Blue Ocean Strategy, 25, 31 Boeing, 6 bounded rationality, 17, 31 business model, in competitive interactions, 5–6, 31 business model, in cooperative interactions, 5 business model, in interdependencies, 9–15 business model, in Nintendo example, 25 business model, in strategic interactions, 4, 26, 32 capabilities, 23, 24, 31 Chrysler, 24 Coca-Cola, 8 collusion, 11, 22 commitment, Dr. Strangelove movie example of, 23–24 commitment, Golden Balls television show example of, 24 commitments, 23, 31 competition, in co-opetition, 6, 7 competition, in strategic interactions, 4, 5–6 competitive interactions, 5, 31 complementors, 4, 6, 31 contracts, 23 cooperation, in co-opetition, 6, 7 cooperation, in strategic interactions, 4, 5, 6 cooperative interactions, 5, 31 co-opetition, 6, 7, 12, 31 delinked game, 26 deterrence, 23, 31 Dr. Strangelove movie commitment example, 23–24 dominant strategy, 19, 31 dynamic interactions, 6

egocentric viewpoint, 9 endowment effect, 17 entry strategy, 12–13 equilibrium, 18, 28–29 equilibrium outcome, 26–27, 31 ethics, in intelligence gathering, 30 Ford, 24 game console industry example, 25 game linkage, 25–26 game theory, basic elements of, 18 game theory, definition of, 9, 31 game theory, Numb3rs television show example of, 17 game tree form, 18, 19, 20, 31 General Motors, 24 Golden Balls television show commitment example, 24 government materials, 29, 30 Hewlett-Packard, 6 holistic interactions, 5–6 Holland Sweetener Company (HSC), 8 Honda, 24 IBM, 6, 14 increased bargaining power, 23, 31 integrative framework for player analysis, 15 Intel, 6, 13–14 intelligence gathering, 29–30 interdependencies, definition, 9, 31 interdependencies, real-world examples of, 13–15 interdependencies, theoretical examples of, 9–13 investor communications, 29, 30 iPhone, 15 Judo Strategy, 25, 31 Kronos Lines (KL), 27–29 Lesser Antilles Lines (LAL), 27–29 linked game, 25–26 market segmentation, 12 matrix form, 18, 19–20, 27–28, 31 Microsoft, 6, 13–14 misrepresentation, 30 Monsanto, 8


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competitive and cooperative dynamics

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