Introduction to the Competitive Strategy Game

Introduction to the Competitive Strategy Game Ian Larkin & Evan Rawley MBA 299: Strategy Section 1 (March 18-28, 2005)

Why are we playing this game? • Game is obviously highly stylized, but it does have quite a few merits: • Gets you thinking about some topics covered in class (first-mover advantage, cost/differentiation strategies, effects of competition) • Simulates team-based approach used in strategy departments of most firms (and consulting) • Requires some degree of number crunching and analytical thinking • Demonstrates power of “psychology” • Not meant to be taken TOO seriously, but definitely should be looked at as an opportunity to learn and have fun!

This game consists of….. • 8 Firms • 4 Markets • 3 Choices • 9 Periods • Each class plays two separate games

Firms • 8 teams with 3-4 players • Each firm has a set of distinct “capabilities” • Costs of entering a market, building capacity, and marginal costs of production • Each firm has a million dollars and access to external financing

Markets • 4 separate markets with distinct supply and demand differences • Supply • Different distributions of costs across firms • Demand • Different market sizes • Different types of “tastes” across markets

Choices & Periods • Each period a firm makes three choices in each of the four markets • Do you enter, how much capacity do you build (or sell), and what do you price at? • Opportunities costs and trade-offs motivate these decisions • The game is played over 9 rounds • Today’s choices impact tomorrow’s outcomes (and vice versa)

What happens in each period… The game aggregates the choices Choices are privately made by firms (due by NOON on due date) Outcomes revealed and time moves forward (Usually late afternoon of due date)

After the game compiles you see the following information for each market… • How much you sold • Approximation of what others sold • What prices everyone charged • How much capacity everyone built/sold in each market • You get an update of your financial health (but not anyone else’s!)

And time moves forward… • Capacity depreciates in value and is eventually scrapped (four periods after it is built) • Interest is paid to you if you still have money in the bank • Interest accumulates if you owe the bank money (interest rates escalate as your total borrowing goes up)

Important rules about choices • You can only enter one market each period • Capacity takes one period to build; therefore price entered is valid ONLY for EXISTING capacity, not any additional capacity added in a period • (What does this mean about pricing in the first period?) • Capacity has 4 periods of productive life; e.g. capacity built in period 1 is productive in periods 2,3,4 and 5 • Capacity can be sold anytime after building it, and is automatically “scrapped” at the end of the 4th productive period; it depreciates according to the schedule in the market profile document • At the very end of the game (period 9), all capacity is sold automatically

Basic flow of game Team choices in each round 1 2 3 4 5 6… Old capacity 0 100 100 200 200 100 Price -- 20 30 20 15 15 Capacity change 100 0 100 0 0 100 ------------------------------------------------------------------------------------- Units sold -- 100 50 120 150 100 Revenue -- 2000 1500 2400 2250 1500 Questions: • Assuming no more capacity is built, how much capacity will this team have in period 7? Period 8? Period 9? • Do you think this team is playing the game well?

What you are responsible for each period… • Period 1: Enter into one market and choose capacity • You can add or subtract capacity later in the game • Periods 2-8: Manage entry, capacity, and pricing in all four markets • Period 9: Choose price only

Some notes on game play • You don’t ever formally enter or exit a market – just build capacity in the market you want to enter. • You should only enter capacity CHANGES in each round. If you’re happy with your current capacity, only enter a market price. • There are no inventories in this game. You build to order depending on how many units are demanded at your price. What does it likely mean if you sold all your capacity? If you sell less than capacity, you are not charged the MC of production for the unused capacity in your factory.

How to play the CSG • Go to the website: http://csg.haas.berkeley.edu • Scan through the list and choose the game corresponding to the game number I sent you earlier in the week • Clicking on that game will show you the following screen…

Here is where your private information is.

Notice the use of the word change

Four Important Ideas • Understanding your cost structure and where you fall in each industry • Understanding demand • Developing a coherent initial strategy based on these two forces • Using information gained in each round to update your strategy (marginally or radically….)

Where should we get started? • You have 3 pieces of information: • Individual firm cost information (private) • Market profiles (public) • Sample/simulated data on market demand with monopoly seller (public) • You don’t know others’ costs but get a good idea of your cost position • Markets are quite different in their economics and probable competitive dynamics

Three types of costs • Entry cost (EC): one-time sunk cost to enter an industry • Note, if you ever completely leave an industry, you are charged the EC again if you re-enter! (May be worth leaving one unit of capacity as an option) • Capacity cost (K): cost paid per unit to build capacity, which has 4 units of productive life • Again, K can be sold back according to depreciation schedule, and is automatically sold back (e.g., scrapped) after 4 productive periods • Marginal cost (MC): unit cost to produce a good • “Build to order” system so there are no inventories; you only build what is demanded in a certain period, up to your capacity constraint

What does my cost data mean? • The market profile document lists mean and SD for all costs in a market. Costs are distributed normally, which means that, on average, 68% of teams SHOULD have costs within one SD of mean. (Of course, with only 8 teams in a game, weird things can happen…) • Example: Market B and fictional “Team 501” • Mean EC=50,000, SD=3,000 Team 501 EC=52,541 • Mean K=20, SD=4 Team 501 K=8 • Mean MC=220, SD=40 Team 501 MC=212 • Question: Is Team 501 well positioned in Market B?

Be careful! • Costs are distributed normally, but with only 8 cost draws in any game, anything is possible! • Normality only holds with LOTS of draws • Example from last year’s game: capacity costs in market D (capital intensive market) • Mean K=$1,600; SD=400 • Actual team draws: • 1246 • 1109 • 1764 • 957 • 1002 • 1532 • 1261 • 1054 You can and should use scenario generators in Excel or other packages to determine where you stand in expectation; for example, the chance that team 1 was the lowest-cost team in this market was only ~5%!

Thinking about economics • Total costs, assuming entry in period 1 and constant capacity Y (and orders of level N per period): • EC + K*Y + MC*N*4(for periods 2-5) + K*Y + MC*N*4(for periods 6-9) • Market economics look VERY different depending on levels of EC, K, MC • Total revenue (assuming constant price): • N * 8 * price (for all periods) + capacity scrap costs (in periods 5 and 9) • Note: When you spend money on EC, K, Y etc, you incur opportunity cost of 2% per period (assuming you have money in the bank!) • You really need to do your homework to understand whether EC, K or MC are most important in markets, and also how much capacity you should build (unused capacity has a cost, both real (wasted K) and opportunity (because you can always sell it back for greater than scrap value))

Understanding the Differences Between the Four Markets • Market A: modest differentiation, moderate capital requirements, moderate marginal costs • Like refrigerators or other consumer durables (?) • Market B: low capital cost, high MC, differentiated • Like apparel (?) • Market C: moderate capital cost, low MC, highly differentiated market • Like business software (?) • Market D: high capital / sunk costs, low MC, undifferentiated • Like memory chip production (?) • Analogies are not meant to be taken too seriously.

How can I start to think about demand and pricing? • Market demand and appropriate market prices are not as intuitive as the cost side, so we’ve given you additional information • For each market, we have put together 20 simulated “rounds” of demand, using one seller offering a single price (e.g., a monopolistic market – this is the “monopoly pricing exercise” that’s on the website) • You can use this data to calculate what your company would charge, and what capacity it would build, if it were a monopolist • What complicates the use of these results in the actual game? • Would you ever charge more (and produce less) than you would under a monopoly?

Sample price and quantity demanded Market A sample data

The P/Q relationship might not be linear Note: in Excel’s chart formatting toolbox, you can ask it to automatically fit the data to these and many other types of functions

Regression estimates of the P/Q relationship Regressing P=a+b*ln(Q) Notes: Regression command in Excel is under “Tools > Data Analysis > Regression” The P=a+b*ln(Q) form fits the data well and is easy to interpret, but feel free to use other functional forms if you deem fit. Doing so could make the analysis more complicated.

Leading to easy calculation of monopoly price • Our functional form assumption was P=a+b*ln(Q) • In our regression estimate, a=1104, b=-111.7 • Because of our functional form assumption, the optimal monopoly price is MC-b. So if your MC in Market A is 50 (which is the market average), the optimal monopoly price would be 161.7 • We can put this P into our function to get an optimal monopoly quantity, in this case (with a little math, which Excel can do for you) optimal quantity = 4605 • Note: if you do not use the P=a+b*ln(Q) functional form assumption, the optimal price will not be MC-b. You have to set up a profit function, take FOCs, etc. It’s actually not too hard, if you want to work with other functional forms.

Usefulness and problems with this approach • Why is this result useful? Would you ever price above your optimal monopoly price? Would you expect capacity in a competitive market to be higher or lower than in a monopoly? • What are the problems with this? • Not everyone has the same costs…… so your monopoly P and Q are not the same as everyone else’s • If there are multiple firms in the market, the monopoly P and Q does maximize joint profits. However, it doesn’t maximize profits for any individual firm, so everyone has incentive to defect (cartel problem) • In our example regression, assuming 3 firms split the market evenly, they can each make a profit above MC of $170,000 per period if they collude on monopoly P and Q. If one firm drops its P by 5%, it will steal demand from the other firms and increase profits by over $20,000, while the other two firms both lose over $15,000 in profit. Note that total profits went down, but defector’s profits went up. Hallelujah competition!

Other notes on demand and pricing • Consumers have some degree of “brand loyalty,” and are willing to pay a price premium for their preferred brand. The degree to which they are willing to do so differs by market and its exact nature is unknown • You can get an idea of the “brand loyalty” premium in each market by looking at the “brand substitution” matrix in the “Market Profiles” document. Market D has almost no brand loyalty! • If a customer’s preferred brand is not offered, she only looks at price • Demand “expands” somewhat with additional firms • E.g. total market demand for two firms both charging X will be greater than total market demand for only one firm charging X • You can get an idea of how much demand expands by looking at the “market demand & effect of brand proliferation” matrix

Information is critical – good teams adapt flexibly to ongoing information given • In each round, you’ll get important pieces of information • How many units you sold (exact figure, only known to you) • Your financial position (can use it to update your model, if you have one) • Capacity changes by each competitor • Prices charged by each competitor • Total approximate market demand • Since you have the same information as they do, except their cost profiles, you can try to “guestimate” competitors’ cost profiles • There’s also an opportunity to make a “public statement,” which can be very strategic • Using public statements to collude will result in SEC fines • Mentions of suggested pricing or capacities strictly not allowed

How you are evaluated • You are required to write a 1-page “journal” of your team’s actions and strategies at 3 specific times: • Directly after periods 1, 5 and 9 (due next section/class) • First journal entry due Friday, April 1 in section • “Journal” explains rationale for your strategic moves (especially recent ones) and what you expect going forward • Last journal entry will be a bit different, but we’ll explain it later • Should be done as a professional-type “memo” to public, board of directors, etc. (making format professional not important but making content professional is) • Journals only returned at the end of the game; no comments will be given before that; also, journals will remain completely private (so you can talk about your costs, etc) • Your CSG grade also depends on the end financial state of your firm, but to a lesser extent than the journal • Initial cost position will be taken into account

Money • Previous students have suggested adding a real financial element to the game to help incentives and make the game even more fun • Note: participation is voluntary – if your team doesn’t want to play for money, let your professor know; it won’t affect your grade • Idea: you pay $20 to play the game. You will get $1 for every $100,00 in the bank at the end of the game, but will pay $1 for every $100,000 in losses • $2 million = breakeven • Losses capped at $40 ($4 million); no upside cap • Last year this would result in the class “breaking even” on average; in other years teams would average as much as $10-15 in winnings per team

Expectations and Odds and Ends • Take the game seriously, and try to use concepts you learned in micro and the current strategy course (because many of them are actually helpful) • You do not need the perfect model • Psychology is very important • Good strategies don’t always map to good outcomes, and vice versa • Cheating’s no fun (Bernie Ebbers is going to jail, and so will you)

Introduction to the Competitive Strategy Game