The right game use game theory to shape strategy summary

Strategy Ramon Casadesus-Masanell, Series Editor

Competitive and Cooperative Dynamics RAMON CASADESUS-MASANELL HARVARD BUSINESS SCHOOL

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+ INTERACTIVE ILLUSTRATIONS

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Table of Contents

1 Introduction.................................................................................................................................................................. 3

2 Essential Reading .................................................................................................................................................4 2.1 Types of Strategic Interaction ......................................................................................................4 2.2 Preparing for the Game ....................................................................................................................... 7

What You Bring to the Game: Added Value ................................................................ 7 Anticipating the Game: Interdependencies, Player Analysis, and Game Theory........................................................................................................................................ 8

2.3 Playing to Win (or Win-Win) .................................................................................................... 23 Changing Added Value: Commitments and Capabilities .......................... 23 Changing the Scope of the Game ........................................................................................ 24 Changing the Boundaries: Linking Games ................................................................. 25

2.4 Conclusion ...................................................................................................................................................... 26

3 Supplemental Reading ................................................................................................................................ 26 3.1 Reaction Curves and Price Leadership ........................................................................... 26 3.2 Gathering Intelligence ...................................................................................................................... 29

4 Key Terms ...................................................................................................................................................................31

5 For Further Reading ...................................................................................................................................... 32

6 Endnotes ..................................................................................................................................................................... 33

7 Index ................................................................................................................................................................................ 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 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 shrink 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.

A

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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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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 capture 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 provides 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 complementary 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 replace. 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 low- calorie 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 seek 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

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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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 legal 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.

FIGURE 3 Business Model for Boats with Heavy Discounts by Innovator

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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 service.

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

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

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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.

Interdependencies: Real-World Examples The interdepedence between the Innovator and the Sailmaker is analogous to the Microsoft- Intel 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.

FIGURE 5 Entry Strategy for Sailmaker with a Bundled Sail at a Low Price (Choice 1)

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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.

FIGURE 6 Economic Logic and Interdependencies of Intel’s and Microsoft’s Respective Business Models

Source: Reprinted from Harvard Business School, “Competing through Business 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.