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2016, H.W. Stuart, Jr. All rights reserved.

Game-Theoretic Business
Strategy: DROM B8122
Prof. Gus Stuart
Spring 2016

Class 1: Introduction

Contents
2

Course Logistics
Course Introduction
Introduction to Value Creation and Profitability
Examples (loosely motivated by Harnischfeger case)

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Grading & Requirements

3

Preparation & Survey Questions

Participation
Diagnostic Quiz
Final Paper (individual or group)

24%
16%
20%
40%

NOTE: Attendance is part of Preparation grade.

NOTE: This course is best taken for the learning
experience, not for a grade.

Preparing for Case Discussions

4

Read the case.

Think about the study questions.
Be prepared to justify your answers in class.

Be aware of the assumptions behind your analysis.

Base your analysis on case facts, and please avoid
on-the-side research, including hindsight.
Answer the survey question(s) by 9:00am the
morning of class.
Meet in a study group to review the case and
questions.

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Class Participation: Guidelines

5

Common courtesy:
No late arrivals or early departures
No laptops; cell phones off

Participate!
Listen to your classmates. Understand why they
are saying what they are saying.
Test your reasoning. Allow yourself to be wrong.
(Better to be wrong now than when the
consequences of your decisions are for real.)
If you are not prepared, please let me know
before class.

Course Outline (subject to change)

6

Value and Competition

Class 1: Value Creation and Unrestricted Competitoin
Class 2: Profitability and the Value Gap
Class 3: Capacity limitations; non-constant marginal
costs
Class 4: First-Mover Advantages

Strategic & Tactical Moves

Class 5: Detering entry
Class 6: Restrictions
Class 7: Managing Competition
Class 8: Shaping Beliefs

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Course Outline (cont.)

7

Corporate Strategy
Class 9: Quiz, Synergy ?
Class 10: Leverage ?
Class 11: Winner-take-all?
Class 12: Does bundling deter entry?
Class 13: Global entry; Review

Administrative Information
8

My contact information:
office hours:
e-mail:
web:

By appointment
hws7@gsb.columbia.edu
www.columbia.edu/~hws7

Canvas
course syllabus
exercises
class slides
other course documents

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Course Introduction

Course Objectives
10

Provide you with the theory to understand why a

given company is (or is not) profitable.
Provide you with perspectives for assessing the
sustainability of a given companys profitability.
Enable you to identify the substantive issues behind
the trends and frameworks in the strategy field.

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What is Strategy?
11

Investments
Materials, Services, etc.
Capital
People

Your Firm

Revenues

(Economic)
Costs

Products,
Services

Simply put, your strategy is your plan for

having Revenues exceed Costs over time.
(The theory for why you are (will be) making
money.)

But will revenues exceed costs?

12

Investments
Materials, Services, etc.
Capital
People

Your Firm

Revenues

(Economic)
Costs

This is a deceptively hard problem because

business is

Products,
Services

Interactive
Dynamic

How do we attack this problem?

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A Deceptively Hard Problem

13

Interactive: our ability to make money usually depends

upon what other people do. For instance, whether
customers will buy from us and suppliers sell to us.
Furthermore, the prices of competitors and the prices
of suppliers (our costs) can change in response to our
actions.
Dynamic: the context is often changing. Players enter
and exit, tastes change, technologies change, etc.

A Deceptively Hard Problem (cont.)

14

Interactive
Good news: our current business context can be modeled
by a game.
Bad news: typically, the game is hopelessly complex.

Dynamic
The game might change due to external factors.
The existing players might find ways to change the
game.

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How to Attack the Problem

15

The key problem of strategy: how to analyze an

interactive and dynamic situation?
Through the years, many frameworks and approaches
have been proposed to address this problem. Taken
collectively, the various frameworks do not provide a
coherent story.
Recent advances in game theory have provided a
better way.

Solving the Interactive Problem

16

Identify the players that are relevant to your business.

Consider the possibilities for value creation among
these players.
Consider each players possible profitability under an
assumption of unrestricted competition.
The first two tasks describe a business game.
The third task describes the analysis of the game.
By focusing on value creation, one can by-pass the
interactive complexity and get to where prices should
end up and to what profits should be.

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Solving the Dynamic Problem

17

With the current business context described by a

game, the dynamic problem reduces to answering this
question: how might the game change?
For example,
when assessing the sustainability of our profitability, we
ask how others might change the game,
when trying to improve our existing profitability, we ask
how we might change the game, and
when considering a new venture, we ask how both we
and others will change the game.

How to Attack the Problem (cont.)

18

This approach has formal game-theoretic foundations

(games in characteristic-function form).
It requires thinking in terms of value creation and
competition.
It is a refinement of what is called added-value theory
or value-based business strategy.
The art of this approach is in applying the theory.

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Our Approach
19

Identify the relevant players: those with whom we

create and capture value
Consider the total value created by these players (the
Pie)
Assess each players range of possible profits under
unrestricted competition.
Assess whether competition is, in fact, unrestricted.
Dynamic concerns: how might the game change? In
particular, is our profitability sustainable?

Two Basic Questions

20

Why is your firm profitable? In particular, why

hasnt competition competed away your profits?
Will an anticipated strategic action lead to
profitability?

10

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21

Value Creation and Profits

A Brief Introduction

What is the Pie? A starting point

22

Fez, Morocco : Photo, TravelAdventures.org

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The Pie? A starting point (cont.)

23

The buyer should have a reservation price: a price above which

he or she is not willing to buy. We call this a willingness-to-pay
(WTP).
The seller should have a reservation price: a price below which
he or she is not willing to sell. We call this the sellers economic
(opportunity) cost.
WTP

Buyer
Profit
price

The Pie
Seller
Profit
cost

Value Creation in Business Strategy

24

Value is created by businesses operating together with

their customers and suppliers.
Customer
Products or Outputs
Business

Monetary
Flow

Resources or Inputs
Supplier

A firm does not create value on its own.

12

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Value Creation
25

($)
Willingnesses-to-pay
Buyers Shares (Profits)
Price
Firms Share (Profits)

Value Created
Cost

Suppliers Shares (Profits)

Suppliers Costs

Value Created = Willingnesses-to-pay minus Suppliers Costs

Note: Suppliers Costs are the suppliers economic (opportunity)
costs for supplying a relevant player.

Profits
26

($)
Willingnesses-to-pay
Buyers Shares (Profits)
Price
Firms Share (Profits)

Value Created
Cost

Suppliers Shares (Profits)

Suppliers Costs

Profits are determined by prices and costs. We will focus on

where they should end up in a competitive situation.
Profits are a piece of an economic pie!

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Profits (cont.)
27

28

But where will prices and costs end up?

How do we model the interactions between buyers,
competitors, suppliers, etc.
If we modeled every possible action, how complicated
would the model be?

But we probably cant even describe all the actions.

An Experiment
Play A Basic Game

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29

Unrestricted Competition

Modeling Complex Business Contexts

30

Do not attempt to describe how the game is played

Instead, put bounds on possible outcomes of the game

State a principle bounding how much value each player

can get

15

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The Contributed Value* Principle

31

The DEFINITION:
For each player i, the CONTRIBUTED VALUE of player i
=
Total pie
with
player i in
the game

The PRINCIPLE:
Simultaneously,
for each player i,

Total pie
without
player i in
the game

player is contributed
value

Slice
to
player i

*Also called added value

The Argument Behind the Principle

32

Suppose instead,
for some player i,

Slice

> player is
Slice
to
to player i contributed value
player i

That is:
Slice
to
Slice
player
i

to
player i

>

Total pie
with
player i in
the game

Total pie
without
player i in
the game

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The Argument (cont.)

33

Rewriting:
Slice
to
player i

>

Sum of slices
to Slice
other
to
players
player
+
Slice
to
player i

Rearranging:
Sum of slices
Total pie
to other
without
players

player i in
the game

>

Total pie
without
player i in
the game

Sum of slices
to other
players

The Argument (cont.)

34

So, the other players would be able to make a better

deal among themselves without player i !
A situation where player i is about to get more than
his/her contributed value does not hold up
The argument is obvious or, almost obvious,
A key element:
The other players are able to make this better deal.
We call this the unrestricted competition assumption.

17

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Unrestricted Competition
35

If we have unrestricted competition, then, for any

group of players, the following cannot happen:
Sum of
slices to a group
of
players

36

<

Total pie the

group can
create on
their own

Loosely, no good deal goes undone or no money is

left on the table.
Unrestricted competition implies the contributed value
principle.

Examples
(Loosely motivated by Harnischfeger case)

18

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Our Approach
37

Identify the relevant players: those with whom we

create and capture value
Consider the total value created by these players
(the Pie)
Assess each players range of possible profits under
unrestricted competition.
Assess whether competition is, in fact, unrestricted.
Dynamic concerns: how might the game change? In
particular, is our profitability sustainable?

Relevant Players
38

Harnischeger: the company whose profitability we are

concerned with
Kranco: the only competitor we think will react to us
One buyer: the potential user from pg. 6 of the case
(we assume the buyer uses 4 mobile log stackers)
We wont talk about the suppliers for simplicity.
(Assume, say, that the suppliers prices (our costs) our
established by market prices.)

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Example 1
39

The buyers perspective:

$9M

WTP

Cost
$2.5M
Harnischfeger

$9M

$2.5M

WTP

Cost

Kranco

Each value stick represents a firm.

Example 1 (cont.)
40

$9M

WTP

Cost
$2.5M
Harnischfeger

$9M

$2.5M

WTP

Cost

Kranco

What value can be created?

Only one crane will be sold, so the value creation is
1 x ($9M - $2.5M) = $6.5M

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Example 1: Who captures value?

41

$9M

WTP

Cost
$2.5M
Harnischfeger

WTP

$9M

$2.5M

Cost

Kranco

Where do we put p in the above picture?

Who contributes value?

42

Remember: a players contributed value is defined as the

total value that can be created by the relevant players
minus the value that could be created if the player were
not in the game.
Loosely, your contributed value is the Pie minus the Pie
without you.
Harnischfegers contributed value is 0. Why?
Krancos contributed value is 0. Why?
What does this imply about the price the buyer will pay?
Does it matter whom the buyer buys from?

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Value Capture (cont.)

43

$9M

WTP

Cost
$2.5M
Harnischfeger

$9M

$2.5M

WTP

Cost

Kranco

Harnischfeger contributed value (ConV) = 0, implying

Harnischfeger price of $2.5M
Kranco ConV = 0, implying Kranco price of $2.5M
Buyer captures all the pie, i.e. $6.5M

Example 2
44

Harnischfeger finds a way to lower its costs.

$9M

WTP

$9M

$2.5M
$2.0M

Cost

WTP

Cost

Kranco

Harnischfeger

What is the pie? Krancos ConV? Harnischfegers

ConV?

22

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Example 3
45

Harnischfeger finds a way to increase a customers

WTP for its crane and service
WTP

$10M

WTP

$9M

Cost
$2.5M
Harnischfeger

Cost

$2.5M

Kranco

What is the pie? Krancos ConV? Harnischfegers

ConV?

Example 4
46

Harnischfeger (or Kranco) gets multiple buyers

interested at once. Each company only has one crane
ready to sell.
$9M

WTP

Cost
$2.5M
Harnischfeger

$9M

$2.5M

WTP

Cost

Kranco

What is the pie? Krancos ConV? Harnischfegers

ConV?

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Conclusions
47

Challenge of strategy is, in part, the challenge of

managing an interactive and dynamic environment
To cut through the complexity,

Identify who is involved in creating and capturing value

with you.
Think in terms of total value creation.
Think in terms of individual value contributions.

Two things to practice:

Thinking about the larger pie of which profits are a

piece
Thinking of price as a consequence of competition

References
48

An Introduction to Business-Centered Economics,

Borg, Brandenburger, and Stuart, April 1998.
Value-based Business Strategy, Brandenburger
and Stuart, Journal of Economics & Management
Strategy, Spring 1996, 5-24.

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