WHERE DO PAYOFFS COME FROM? Adam Brandenburger

WHERE DO PAYOFFS COME FROM?Adam Brandenburger filename: where-do-payoffs-come-08-04-10

Decision Trees and Game Trees Again Deploy missiles Ke Kh Object ? Accept Don’t Status quo Kh wins • In a business context, we think of the choices (entry, position, capacity, …) as leading to a game of bargaining among the players (firms, suppliers, and buyers) This and subsequent slides draw on: (i) “Value-Based Business Strategy,” by Adam Brandenburger and Harborne Stuart, Journal of Economics & Management Strategy, 5, 1996, 5-24; (ii) “An Introduction to Business-Centered Economics,” by Scott Borg, Adam Brandenburger, and Harborne Stuart, unpublished,1996; (iii) “Biform Games,” by Adam Brandenburger and Harborne Stuart, Management Science, 53, 2007, 537-549.

A Game Tree of Bargaining? … … … … … … … … … … … … … … … …

Complexity Pictures: Wikimedia Commons * Estimates from http://en.wikipedia.org/wiki/Game_tree_complexity

An Alternative Approach: Added Value • 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

The Added-Value Principle • The DEFINITION: • For each player i, the ADDED VALUE of player i = Total pie with player iin the game Total pie without player i in the game _ • The PRINCIPLE: • Simultaneously, for each player i, Slice to player i ≤ player i’s added value

The Argument Behind the Principle Suppose instead, for some player i, Slice to player i > player i’s added value Total pie with player iin the game That is: Total pie without player i in the game Slice to player i _ >

The Argument cont’d Rewriting: Sum of slices to other players Total pie without player i in the game Slice to player i _ + > Slice to player i Rearranging: Total pie without player i in the game Sum of slices to other players < >

“There is nothing to take if you have nothing to offer.” -- Demosthenes, 4th century B.C. The Argument cont’d • So, the other players will 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 added 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 NO FRICTIONS assumption • We will come back to this assumption later

Example: A Card Game Player #1 holds 23 black cards Player #2 holds 12 red cards Player #3 holds 6 red cards Player #4 holds 4 red cards Player #5 holds 3 red cards Player #6 holds 1 red card A pair of cards is worth $100 (one black and one red card, with no additional requirements) Picture: Wikimedia Commons How might the negotiations proceed?

Example cont’d: Added-Value Calculations Player #1’s AV = Player #2’s AV = Player #3’s AV = Player #4’s AV = Player #5’s AV = Player #6’s AV = Under the AV Principle, what is the minimum value Player #1 can capture? Picture: Wikimedia Commons Picture: Wikimedia Commons

“The [NFL] league likes to leave one prominent city without a football franchise, like an empty seat in musical chairs”* Examples of Undersupply … “When the decision [about hosting the 2012 summer Olympics] is announced Wednesday in Singapore, there will be cheers for the winner and tears for the losers. But the also-rans may have a reason to smile: at least they won’t have to pay.” ** Pictures: Wikimedia Commons * John Vrooman, Vanderbilt University, in “In a League of Its Own,” The Economist, 04/27/06 ** “Winners Lose in Olympic Bid,” by Gordon T. Anderson, cnnmoney.com, 07/05/05

Undersupply: Size as Well as Division of the Pie “It’s a tough balancing act. The rich don’t want to wait, but if you have a product you don’t have to wait for it isn’t exclusive, and nobody wants it. Ferrari’s problem is a good one to have. Porsche over-built their Carrera GT, and in an embarrassing move had to scale back production at the end of the model life because dealers already had too many. Mercedes also over-estimated the appeal of the McLaren SLR, and built too many and now dealers can’t give them away. Ferrari knows they need to err on the side of caution, and limit production. I think it is better to annoy a few impatient customers and make them wait rather implode your entire market and exclusivity. That said, they need much more transparency on their waitlist, since people do think you can buy your way to the top…. Maserati looks like we’ll have our own waitlist problem with the new GranTurismo. Instead of getting 400 this year, we might get less than 200, and we already have a dozen people who insist they must have the first one.” -- Tim Philippo, Marketing Manager, Maserati North America, Stern MBA 2004 MaseratiS.p.A. lgo

[Sir William] Lyons used to say: “One car less than the market needs is good business. One car more is a disaster.” * -- *Bob Berry, Jaguar public relations and publicity manager at the time of the 1961 launch of the E-type; in Classic Cars, February 2006, p.47 Undersupply cont’d Picture: Wikipedia

WHERE DO PAYOFFS COME FROM? Adam Brandenburger