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Strategy
Ramon Casadesus-Masanell, Series Editor

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+ INTERACTIVE ILLUSTRATIONS

Competitive
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and Cooperative
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Dynamics
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RAMON CASADESUS-MASANELL
HARVARD BUSINESS SCHOOL
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8131 | Published: June 30, 2015


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Table of Contents

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

2 Essential Reading .................................................................................................................................................4

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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

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

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


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

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

7 Index ................................................................................................................................................................................ 34
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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


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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

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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

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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

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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.
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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
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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.
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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.
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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

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cooperatively, as they create and capture value. In a dynamic environment, can a firm predict

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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

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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.

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2 ESSENTIAL READING

2.1 Types of Strategic Interaction


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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
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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?
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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
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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

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far greater share of this value.

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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

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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.

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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.
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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


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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

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share are too often the only focus of strategists. It is reductive—and dangerous—to see

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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.

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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

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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
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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
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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
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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

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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.
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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
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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


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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
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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,

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added value can be defined as follows:

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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

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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
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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
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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
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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
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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

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those choices for other players?

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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?

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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

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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?
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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
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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

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Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2IRP3fH

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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.
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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,
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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
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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,
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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

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

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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
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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
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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
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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

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profitability would decrease because she would sell fewer boats. She would not only experience

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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)

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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
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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.
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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

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Respective Business Models

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Source: Reprinted from Harvard Business School, “Competing through Business Models (C): Interdependence, Tactical & Strategic
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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
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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
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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

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resulted in a very limited software library for consumers and some subpar offerings because of

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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

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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.

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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?


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Will this perspective lead it to a particular choice?

Michael Porter suggests an integrative framework for player analysis, as seen in Figure 7.

FIGURE 7 Michael Porter’s Integrative Framework for Player Analysis


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Source: Reprinted with the permission of The Free 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.

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
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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 scenarios 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

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Source: Adapted with the permission of The Free 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


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Source: Adapted with the permission of The Free 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.
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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

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fishing market, the Innovator could send a signal that encourages a peaceful, long-term

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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 actions and signals.

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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.

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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
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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
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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 do not own. For example, a firm could focus
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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
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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 icon, 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

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choice. How has the firm behaved in the past? What organizational assumptions or beliefs will

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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.

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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.

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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:
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For every outcome, what is the payoff for each player?
What is each player’s best choice given 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
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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 change its choice unilaterally—the solution is one of
equilibrium (or, more precisely, Nash equilibriumd).
There are two basic ways to represent a game:
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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 columns. 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
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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 accuracy 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

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payoffs in orange.

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FIGURE 10 Player A’s Payoffs (Shown in Orange) in Matrix Form

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In general, the matrix form is useful for games in which players make decisions
simultaneously, meaning that neither player knows the other’s choice 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.
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FIGURE 11 Player A’s Payoffs (Shown in Orange) in Game Tree Form
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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
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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

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

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• 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.
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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
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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 herself.

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

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the Innovator’s choice depends on Newbie’s:

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• 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.

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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

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Newbie.

FIGURE 14 Possible Choices and Payoffs for the Types of Boats that Newbie and
Innovator Manufacture
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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
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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
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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 solution, but this is not relevant for management.

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FIGURE 15 Possible Choices and Payoffs if Newbie or Innovator Offers a Discount

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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

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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
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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
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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
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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.
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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

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irrational retaliation by overreacting under certain circumstances or for taking several turns in

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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

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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)

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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
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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
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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
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timber production, he will think twice about trying to capture more value by raising his prices.
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
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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

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function, a commitment must be known by the other players. Unfortunately, in the movie, the

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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

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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

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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
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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.
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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
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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


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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

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scope. One can choose a focused game that does not lead to an immediate response from the

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other player. In game theory terms, this option entails choosing a game where, from the other

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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

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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

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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 also-
ran 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
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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 because
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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
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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
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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

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own trading boats at a steep discount. In this way, Newbie protects his own profitable cruise

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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

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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

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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
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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
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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
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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
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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.

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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

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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

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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 costs 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
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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)
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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,
No

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

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

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Source: Phillip E. Pfeiffer and James V. Gelly, “Lesser Antilles Lines: The Island of San Humberto (A),” University of Virginia, Darden Business
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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
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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.
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• 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
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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 price 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

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highest payoff. This is where KL and LAL both price at $1,500 per container, giving the latter a

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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

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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.

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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
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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
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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 near-
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and 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 Securities 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 papers, licenses, and manuals. These
may be useful for understanding potential company actions in the areas of product
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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

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unwilling to reveal the full extent of their plans. What others say about a player can help the

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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

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can be immensely useful for evaluating the economic 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

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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 and intentions. Note, however, that
working with such sources demands clear ethical standards, which will be discussed
below.
• Public materials may include books, business press, and even case studies (e.g., Harvard
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Business School studies). These may reveal past behavior, 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
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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
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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
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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

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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 game among various players as a series of
pie when it is out of the game. possible decisions that branch out into the
full set of potential outcomes. Also known as
Blue Ocean Strategy A strategy in extensive form.

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which a firm creates a marketing space that
players cannot or will not attempt to occupy. increased bargaining power
A situation in which one player in an
bounded rationality The limits of actors’ exchange can increase the value it captures
ability to be perfectly rational in making from other players.
decisions.
interdependencies How the choices that
capabilities The know-how to produce a one player makes influences the choices and
good or service reliably.

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payoffs for other players.
commitments Major investments that are Judo Strategy A situation in which a
costly to reverse. weaker company does not compete directly
competitive interactions Interactions with a dominant firm and uses the strengths
in which one firm’s business model causes of the dominant firm against it.
another firm to create or capture less value. matrix form A representation of a game in
a table, with each player’s choices shown
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complementors Companies in one
industry whose products or services increase along the rows or columns. The cells of the
the value of products or services of table show the combinations of the choices,
companies in another industry. each of which is a possible outcome. Also
known as normal form and strategic form.
cooperative interactions Strategic
interactions among companies that help normal form See matrix form.
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make the pie of value bigger for a product or player analysis An analysis of how each
service. player in a game sees its world and its
co-opetition A state of simultaneous choices.
cooperation and competition between firms. price leadership A situation in which
deterrence A situation in which one one company in an industry sets the
company’s actions influence another prevailing price, and other competitors
company to delay or decide not to do follow this company’s lead when they set
No

something it otherwise would have done. their prices.

dominant strategy A choice that makes prisoner’s dilemma A situation in a


sense no matter what the other player does. game in which the players have a much
better joint outcome if no player defects, but
equilibrium outcome A situation in in which each player has a strong incentive
game theory in which neither player can to defect because it cannot communicate
unilaterally improve on its payoff. with other players.

extensive form See game tree form. reaction curve The payoff curve that
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describes a company’s optimal choice for


game theory A branch of economics that any given choice by other players.
studies the economic outcomes of various
scenarios and how those outcomes affect repeat-play games Games in which each
each player’s likely choices. player makes ongoing decisions.

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single-play games Games in which each value capture Interactions by players that

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player has to make a one-time decision. change the division of the pie.

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strategic form See matrix form. value creation Interactions by players
that make the pie bigger.
strategic interaction Situations in which
the business model of one firm affects the
performance of other firms.

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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.

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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.
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Ghemawat, Pankaj, and Patricio Del Sol. “Commitment versus Flexibility?” California
Management Review 40 (Summer 1998): 26–42.
Lichtendahl, Kenneth C., and Samuel E. Bodily. “Airbus and Boeing: Superjumbo Decisions.”
Darden Business Publishing Case UV1312 (Charlottesville, VA: Darden Business Publishing,
2008).
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No
Do

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6 ENDNOTES

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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.

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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).

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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
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(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
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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.
No
Do

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7 INDEX

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added value, commitments and capabilities egocentric viewpoint, 9
with, 23–24 endowment effect, 17
added value, definition of, 7, 31 entry strategy, 12–13
added value, overconfidence about, 17 equilibrium, 18, 28–29
added value, overview of, 7–8 equilibrium outcome, 26–27, 31

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Adidas, 26 ethics, in intelligence gathering, 30
advertising, 20–21, 26, 29
airline industry example, 6 Ford, 24
allocentric viewpoint, 9
American Airlines, 6 game console industry example, 25
Apple, 15 game linkage, 25–26
athletic footwear industry example, 26 game theory, basic elements of, 18
automobile industry example, 24 game theory, definition of, 9, 31

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game theory, Numb3rs television show
Blue Ocean Strategy, 25, 31 example of, 17
Boeing, 6 game tree form, 18, 19, 20, 31
bounded rationality, 17, 31 General Motors, 24
business model, in competitive interactions, Golden Balls television show commitment
5–6, 31 example, 24
business model, in cooperative interactions, 5 government materials, 29, 30
business model, in interdependencies, 9–15
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business model, in Nintendo example, 25 Hewlett-Packard, 6
business model, in strategic interactions, 4, holistic interactions, 5–6
26, 32 Holland Sweetener Company (HSC), 8
Honda, 24
capabilities, 23, 24, 31
Chrysler, 24 IBM, 6, 14
Coca-Cola, 8 increased bargaining power, 23, 31
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collusion, 11, 22 integrative framework for player analysis, 15


commitment, Dr. Strangelove movie example Intel, 6, 13–14
of, 23–24 intelligence gathering, 29–30
commitment, Golden Balls television show interdependencies, definition, 9, 31
example of, 24 interdependencies, real-world examples of,
commitments, 23, 31 13–15
competition, in co-opetition, 6, 7 interdependencies, theoretical examples of,
competition, in strategic interactions, 4, 5–6 9–13
No

competitive interactions, 5, 31 investor communications, 29, 30


complementors, 4, 6, 31 iPhone, 15
contracts, 23
cooperation, in co-opetition, 6, 7 Judo Strategy, 25, 31
cooperation, in strategic interactions, 4, 5, 6
cooperative interactions, 5, 31 Kronos Lines (KL), 27–29
co-opetition, 6, 7, 12, 31
Lesser Antilles Lines (LAL), 27–29
delinked game, 26 linked game, 25–26
deterrence, 23, 31
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Dr. Strangelove movie commitment example, market segmentation, 12


23–24 matrix form, 18, 19–20, 27–28, 31
dominant strategy, 19, 31 Microsoft, 6, 13–14
dynamic interactions, 6 misrepresentation, 30
Monsanto, 8

8131 | Core Reading: COMPETITIVE AND COOPERATIVE DYNAMICS 34


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Nash equilibrium, 18 scarcity, 4–5, 7, 8

t
Nike, 26 Sega, 25

os
Nintendo, 25 single-play games, 21, 32
Numb3rs television show game theory strategic interaction, definition of, 4, 32
example, 17 strategic interaction, types of, 4–7
NutraSweet brand, 8 strategy, choices in, 3
strategy, competition and cooperation in, 5–6
overconfidence, 17

rP
tit-for-tat strategy, 22, 25, 32
Pareto suboptimal, 22 Toyota, 24
Pepsi-Cola, 8 trade sources, 29, 30
personal computer industry examples, 6,
13–14, 15 United Airlines, 6
platforms, 14–15
player analysis, definition, 9, 31 value capture, in Apple example, 15
player analysis, real-world limitations, 15–17 value capture, in co-opetition, 7

yo
player analysis, theoretical examples, 17–18 value capture, in strategic interactions, 4, 5, 32
precedents, 25 value creation, in co-opetition, 7
price leadership, 27, 29, 31 value creation, in strategic interactions, 4, 5, 32
prisoner’s dilemma, 18, 22, 31
public materials, 29, 30

reaction curves, 26–29, 31


repeat-play games, 21, 22–23, 31
op
reputation, 22–23, 25
tC
No
Do

8131 | Core Reading: COMPETITIVE AND COOPERATIVE DYNAMICS 35


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.
Permissions@hbsp.harvard.edu or 617.783.7860