The LSE Summer School 2003

Seminar 05: Game Theory

Class Readings

Business as a War Game: A Report from the Battlefront

Source: Fortune, 30 Septemebr 1996 (Vol. 134 No. 6)

Bell Atlantic's chairman reveals how he and his key players plot and maneuver to stay one move ahead of their opponents.

by Raymond W. Smith

It was one of those beautiful June mornings when all of New York City seems solar-powered: bright, fast, and teeming with energy. I was walking down Sixth Avenue to the hotel where Ivan Seidenberg and I would hold the first official meeting of the management teams of Nynex and Bell Atlantic - the initial step in creating what we believed would be the world's next great communications company. As I walked, I reviewed the complicated policy questions we'd be facing as we put this new company together. Surely, I thought as I jostled along the busy sidewalk, I've been presented with a unique business challenge.

Lost in my own thoughts, I caught a glimpse of a dark-haired man with a mustache coming toward me, walking with a similar air of purposefulness and distraction. As he approached, I realized why I'd picked him out of the hundreds of pedestrians I'd passed. It was Time Warner's chairman, Jerry Levin, whose intended takeover of Turner Broadcasting had been pending for several months. So much for my unique challenge.

Jerry looked at me, smiling. "How's your merger, Ray?" he asked.

"Fine, Jerry," I replied. "How's yours?"

We swapped war stories, shook hands, and went our separate ways-each continuing to plot his ambitious and, no doubt, mutually exclusive vision of the future of communications. It made me wonder what all those other people walking down the street - the real arbiters of the future - had up their sleeves that would make Jerry's and my lives even more complicated in the months to come.

I relate this story because it illustrates a basic, even a defining truth about modern management: Leadership in the late 20th century is all about making decisions in the midst of complexity - something that traditional management systems fail woefully to prepare executives to do. To succeed in this sometimes baffling environment, managers have to devise dynamic new systems to assist them. These systems must do the following:

They have to give managers a way of analyzing the impact of conflicting, sometimes contradictory market forces.
They have to eliminate the blind spots that prevent managers from seeing all the consequences of their decisions.
They have to help managers change direction as the environment changes.
And they have to do all this in real time, so that the organization remains limber enough to move at exactly the right strategic moment-and not a moment later.

The closest analog to this kind of system was devised not in the hothouse atmosphere of the business school but rather in the life-and-death crucible of World War II. That's when British navy officers first applied the academic exercise known as game theory to the deadly serious pursuit of trying to outwit German submarine commanders. They developed techniques for analyzing different scenarios, exploring interdependencies, and changing strategies midcourse - all while the action was unfolding around them. In the process, they formed the kind of flexible decision- making structure required in the modern corporation.

To make effective use of game theory, organizations must learn to analyze, adjust, even change direction in midflight, without losing the sense of purpose and action required in the competitive world. At Bell Atlantic, we've found that the lessons of game theory give us a wider view of our business situation and provide us a more nimble approach to corporate planning. We call this system, quite simply, the "manage the business" process.

Several techniques and modes of strategic thinking are central to this system:

Look for solutions that will be correct no matter what happens.

If you make all your investment and marketing decisions based on a single view of the future, you put your company at risk if your assumptions turn out to be invalid. On the other hand, if you make a decision that is correct across a wide range of outcomes, you reduce your risk while maximizing your exposure to growth opportunities.

This is the principle we've used at Bell Atlantic in making decisions about modernizing our telephone plant. We know that, like every telephone company, we have to upgrade our old copper plant with fiber optics and other broadband technologies. We also know that interactive applications are driving the market and that the costs of high-speed lines and other digital technologies are dropping dramatically. However, we don't know precisely how digital content will be delivered. We don't know exactly what the product mix will be - PCs? digital TVs? the new Internet appliances? - or what people will pay for them. And we don't know how digital technologies will become an affordable, mass-market phenomenon.

So rather than commit our capital dollars to a limited technology platform that will be correct based on only one reading of the tea leaves, we have opted to deploy a flexible, full-featured digital network that will deliver high-speed interactive content in any form-data, video, or voice. Meanwhile, we're covering all the bases by supplementing our existing network with new digital technologies and by entering new markets quickly with low-cost, easily deployed technologies such as wireless video. With this flexible strategy, we are in a position to win, no matter how the market develops.

Build a constant reassessment of business assumptions into the planning process.

Most successful executives are temperamentally unsuited to second-guessing their own decisions; once they set out on a certain path, they become emotionally invested in their own assumptions and come to believe that further analysis breeds waffling and indecision. But by establishing an independent review process, you can ensure that your managers are taking changing conditions into account in their plans.

At Bell Atlantic we call this "performance assurance." A senior-level executive is given the responsibility for monitoring our progress on our top 20 or 30 corporate priorities. This highly respected executive works with the operating units to revisit goals and targets, track progress, analyze problems, and basically keep us from marching resolutely down blind alleys. If this executive is carefully selected and performs the task without regard to politics, the operating managers come to regard him or her as a built-in sanity check who helps keep the organization focused and aligned.

Analyze the game through the other players' eyes.

This is a pure game-theory strategy - placing yourself in the shoes of your opponents to understand how they will counter your tactical moves. It is especially important in preventing the tunnel vision that results in a too narrow focus on a single competitor; while you're concentrating on the headlights of the Mack truck coming down the highway, you sometimes don't see the guy on the motorcycle trying to cut you off from the right lane.

There are a number of techniques that can improve a company's competitive instincts. We've used three in particular:

Fishbowl. This exercise brings everybody with an ax to grind on a given issue together in one room, with advocates of certain points of view in the center of the "fishbowl" and executives accountable for the decision on the outside. The experts present their data and debate one another, while the executives evaluate the quality of the facts at hand, expose weak positions, and analyze the strategic options.
Red team / blue team. In this variation of the classic war game, we assign managers to teams representing major competitors and have them plan the strategies they would use to beat us. This team research increases our competitive intelligence and quickens our reflexes by building a competitive awareness into all our actions - rather like a good chess player is always aware of what an opponent will do in response to the next move.
Future mapping. This is a fancy name for a way of looking at different scenarios for the future. We look at several alternative futures, or "end states," for our business, assign a probability to each one, and identify the forces that will determine whether that scenario will happen. The key is to select those actions with the biggest returns, the least risk, or both. Knowing that we can't manage every single variable, we're trying to make sure we're concentrating on those that will give us the most bang for the buck.

Don't just play the game, change the rules.

In their new book, Co-opetition, professors Adam Brandenburger and Barry Nalebuff say, "Successful business strategy is about actively shaping the game you play, not just playing the game you find." Or, in a more Zenlike phrase: "There is always a larger game."

Traditional planning models lock managers into assumptions that they find difficult to change. But the "manage the business" process constantly prompts managers to question those underlying assumptions. For example, we asked ourselves several years ago why telephone companies couldn't own the content transmitted over our networks - from directory listings to digitized movies - when our competitors, most notably the cable companies, could. Left unchallenged, this outdated legalism would have severely hampered our ability to compete. So we decided to play the "larger game," arguing that the ban on selling our own content on our networks violated our First Amendment rights. We won - and changed the scope of the competitive game for telephone companies forever.

This fundamental redefinition of our business would not have been possible unless we had a systematic way of reviewing the initial conditions that shape our destiny. This willingness to see ourselves afresh has resulted in a large number of strategic initiatives, from joint ventures to mergers to new-business development, that would have been unheard of in a traditional planning environment. We still have to deliver the goods in the marketplace, but at least we've put ourselves in a position to play the game - which, ultimately, is what successful strategic planning is all about.

Of course, having the right planning process is only half the story. The game-theory approach to business strategy also requires a different kind of corporate manager: flexible, intellectually rigorous, and highly tolerant of ambiguity. It takes a special kind of manager to revisit decisions constantly and reverse course, even at the risk of personal embarrassment and exposure.

It also takes a special kind of company to nurture a climate of open, frank, and relentlessly objective discussion so that all the variables are scrutinized honestly and without political repercussions. The loyalty required in this system differs subtly but crucially from the loyalty that prevails in most hierarchical organizations. This is loyalty not to one's own advancement or one's boss or one's department, but to the truth as it bears on the goals of the organization.

Finally, the success of a dynamic planning process, one that is constantly presenting managers with new and unfamiliar choices, boils down to what I call the "shortstop rule": Know what to do with the ball when someone hits it your way. A modern manager must have the vision, skill, and competitive reflexes to throw to the right base at the right time, without looking at the first-base coach for help. In the last analysis, the game-theory approach to business strategy challenges corporate leaders to build not only a different kind of system but a different kind of team.

Let Game Theory Begin: Anticipating Your Rival

Source: Investor's Business Daily, 25 January 1996

by Gerald A. Achstatter
Anticipating your opponent: It's key to any sport or business. But unlike sports, where there's a winner and loser, you can have win-win and lose-lose situations in business.
When the competition views your actions as beneficial or at least nonthreatening, it's less likely to retaliate. Conversely, seeing your competitors' actions in the same light can avert a costly price war. Visualizing and anticipating your competitor's moves are the venue of a branch of mathematics called game theory - the study of competitive interaction. Companies use it to anticipate their competitors' reactions in order to improve their own decisions.
Last March, the Federal Communications Commission completed the largest application of game theory - the $ 7 billion auction of wireless personal communication services.
Game theory helps firms better assess their own negotiating position. They can also learn how to change the game they're playing rather than just play the existing one.
Having game theory in your corporate ''bag of tricks'' can mean the difference between success and failure. ''Our company only gets to bid on deals once in a generation,'' said Dallas Luby, executive vice president and chief marketing officer at Stamford, Conn.-based General Re Corp., a property/casualty reinsurer. ''We want the best information possible.''
Game Theory also can help firms look beyond the traditional roles of competitors, customers and suppliers, says Barry J. Nalebuff, management professor at the Yale School of Management and author of the forthcoming book on game theory, ''Co-opetition'' (co-authored by Adam M. Brandenburger, business strategy professor at the Harvard Business School). Too often, firms ''leave out complementors.''
''Sometimes, what you do helps me,'' Nalebuff added. An example is the development of a new airplane. They are ''too expensive for one firm to have/develop alone. Airlines share the development cost.''
It's important to note, however, that firms must avoid collusion.
Another reason game theory is catching on is that firms don't want to be at a competitive disadvantage because they failed to use the tool. At General Re, ''Game theory is a significant part of senior management education,'' Luby said.
The real benefit of game theory is finding areas of cooperation, Luby adds. It helps answer the question: ''What's everybody's motivation in the game?''
Allocentrism - putting yourself in your competitor's shoes - is only one side of the equation. Firms must also look at the added value they bring to the table, Nalebuff says. The Holland Sweetener Co. probably wishes it had done so. It tried to compete with Monsanto's aspartame product, NutraSweet, by building a plant to make the product.
All Holland Sweetener succeeded in doing was to make the aspartame market competitive. Coca Cola Co. and PepsiCo Inc. signed long-term contracts with Monsanto prior to the patent expiration on NutraSweet. They both did so at significantly lower prices.
As it turned out, the NutraSweet name had a great deal of value to both Coke and Pepsi something Holland Sweetener couldn't capitalize on.
The absence of any added value doesn't preclude a company from playing in the game, Nalebuff says. But if you don't have added value, ''You had better realize it and get paid upfront.''
By creating a viable competitor for NutraSweet, Holland Sweetener certainly did Coke and Pepsi a great service. But there are instances when game theory ''is not beneficial to anyone,'' said Avinash K. Dixit, economics professor at Princeton University. In designing the FCC's PCS auction, the government worked hard to ensure productive bidding. The reason? ''Each bidder could have benefited from lying in the grass,'' said Evan R. Kwerel, senior economist at the FCC.
The auction consisted of 112 rounds of open bids. To prevent disruptive bids, each bidder was required to maintain active participation in the auction, Kwerel says. In addition, firms that withdrew bids were subject to penalties.
Like the bids in the FCC auction, the actions firms take are interpreted by their competitors as signals. They convey what's important to the company.
''Firms may give false signals'' to confuse competitors, Dixit said. ''But other firms will not give much weight to signals that can easily be mimicked.''
Game theory helps sensitize companies to such actions as false signaling. ''It safeguards you from being taken advantage of,'' Dixit said.
So what's in store for game theory? ''There will be more cooperation between buyer and seller than you've ever seen before,'' Luby said. As a result, ''more and more people are going to use game theory.'' Game theory will continue to grow because of the importance added value plays in business today, Nalebuff says. It ''helps companies define their added value.'''
And firms will have ''to give up old habits such as thinking that business is war and that they must beat the competition,'' Nalebuff added. ''This is true for card games and sports, but not in business.''