WHERE DO PAYOFFS COME FROM? ADDED VALUE Adam Brandenburger

1. WHERE DO PAYOFFS COME FROM? ADDED VALUEAdam Brandenburger filename: where-do-payoffs-come-from-added-value-short-01-02-10

2. Where Do Payoffs Come From? Bob L R This and subsequent slides draw on: “Value-Based Business Strategy,” by Adam Brandenburger and Harborne Stuart, Journal of Economics & Management Strategy, 5, 1996, 5-24 “An Introduction to Business-Centered Economics,” by Scott Borg, Adam Brandenburger, and Harborne Stuart, unpublished,1996 “Biform Games,” by Adam Brandenburger and Harborne Stuart, Management Science, 53, 2007, 537-549 U Ann D

3. Or in the Tree … Ann U D Bob Bob L R L* R*

4. A Game Tree of Bargaining? … … … … … … … … … … … … … … … …

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

6. An Alternative Approach: Added Value

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

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

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

10. “There is nothing to take if you have nothing to offer.” -- Demosthenes, 4th century B.C. The Argument cont’d • So, the other players will be able to make a better deal among themselves without player i! • A situation where player i is about to get more than his/her added value does not hold up • The argument is obvious … or, almost obvious … • A key element: • The other players are able to make this better deal • We call this the NO FRICTIONS assumption • We will come back to this assumption later

11. Adam has 26 black cards Each of his 26 students has a red card The dean offers to pay $100 to anyone handing in a pair of cards (a pair is one black card and one red card, without any further requirements) It is a free-form negotiation between Adam and the students A Card Game Picture: Wikimedia Commons From: Co-opetition, by Adam Brandenburger and Barry Nalebuff, Doubleday, 1996

12. Adam plays again, but has lost three of the black cards • Each of the 26 students again has a red card • As before, a black and a red card together are worth $100 A Card Game cont’d Picture: Wikimedia Commons From: Co-opetition, by Adam Brandenburger and Barry Nalebuff, Doubleday, 1996

13. Added Values in the Card Game • First version: • Adam’s added value = • Each student’s added value = • Second version: • Adam’s added value = • Each student’s added value = • A variant of the second version—in which 5 students form a coalition: • Adam’s added value = • The coalition’s added value = • Each remaining student’s added value = • Other calculations …

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

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

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

17. Now … What Exactly is the Pie (aka the Total Value Created)? Who are Google’s customers? Who are a charity’s customers? Customers Products/Outputs “Non-material” resources: Human, Capital, Information, … Business Monetary Flow Resources/Inputs Suppliers Note: Value Chains can have additional links—e.g., from business to distributor, or from to retailer to end-user

18. In an effort to coax more money out of top givers, charities are increasingly turning to extreme travel as a fund-raising tactic—sending donors where their money is…. “They want to see it—the land being preserved, the kids being saved,” says Jeff Bradach, managing partner of the Bridgespan Group, a consulting firm that advises foundations and nonprofits…. Unlike fundraising dinners, which can raise money quickly, field visits can pay dividends for years, charities say—and eventually yield more money. * Who is a Customer cont’d http://www.bridgespan.org/ * “Have Donation, Will Travel,” by Katherine Rosman, WSJ, 10/01/04

19. Berlin-based publisher Springer is buying BioMed Central (BMC), the world’s largest publisher of open-access journals. Launched in 2002 by entrepreneur VitekTracz, BMC pioneered the concept of making full-text articles freely available at the time of publication. Along the way, the company began charging authors, who once could publish for free; the fee for its priciest journals is now $2390 per article. The company publishes more than 180 titles and last year had profits of €15 million…. The deal shows that “open access is a successful business model,” says epidemiologist R. Bryan Haynes of McMaster University in Hamilton, Canada, a member of the board of trustees for London-based BMC. Springer will retain the open-access model…. * Who is a Customer cont’d http://www.biomedcentral.com/ * “‘Free’ Gets Sold,” by Jocelyn Kaiser, Science, 10/17/08, p.359

20. How much does a certain customer ‘value’ the product? • How much does a given supplier ‘value’ the resource? • What is the difference between the two quantities? • This sounds circular—how to proceed? Definition of the Pie (aka the Value Created) Receive product and give $s Willingness-to-pay (“W2P”) is the ceiling Customer Status quo Give resource and receive $s Supplier cost (“SC”) is the floor Supplier Status quo

21. Finally … the Pie $ Willingness-to-pay Value received by customer Price Value received by business Cost Value received by supplier Supplier cost The Pie (aka the Value Created) = W2P – SC

22. Determining W2P and SC We will look at both quantitative and qualitative assessments

23. Exercises on Added Value Q1: (Looks at Porter-style positioning from the point of view of added value) There are three firms, labeled A, B, and C, each able to produce a single unit of a product. There are numerous suppliers, each of which can supply the necessary input to only one firm; each supplier has a supplier cost of $4. There are two buyers, each interested in buying at most one unit. Both buyers have a willingness-to-pay of $9 for each firm’s product. a. What is the total value of this game? b. What is the added value of each player? c. How much value do you expect each player to capture? d. Now suppose that firm A has the option of either playing the game just described, or playing the following modified game. Suppliers still have a supplier cost of $4 for firms B or C. Both buyers have a willingness-to-pay of $9 (as before) for firm B’s or firm C’s product. But now, suppliers have a supplier cost of $5 for supplying firm A, and buyers have a willingness-to-pay of $11 for firm A’s product. (Think of this situation as one in which firm A can pursue a Porter-style differentiation strategy by using a higher quality input—which has a higher supplier cost—to improve its product in the eyes of the buyers.) Recalculate the added values of the players, and find how much value each player will capture, in the second game. Which game do you expect firm A to choose? Based on “Exercises on Added Value,” teaching material, 12/10/07, by Adam Brandenburger, Ken Corts, and Harborne Stuart, 12/10/07; and “The Supplier-Firm-Buyer Game and Its M-sided Generalization,” by Harborne Stuart, Mathematical Social Sciences, 34, 1997, 21-27

24. Exercises on Added Value cont’d Q2: (Looks at the idea of positioning more generally) There are three firms, labeled A, B, and C, each able to produce a single unit of a product. There are numerous suppliers, each of which can supply at most one firm. Each supplier has a supplier cost of $2 of supplying firm A, a supplier cost of $3 of supplying firm B, and a supplier cost of $5 of supplying firm C. There are two buyers, each interested in buying at most one unit. Each buyer has a willingness-to-pay of $10 for firm A’s product, a willingness-to-pay of $12 for firm B’s product, and a willingness-to-pay of $13 for firm C’s product. Thus, firm A is the cost leader in this market, and firm C is the differentiator or high-quality provider. a. What is the total value of this game? b. What is the added value of each player? c. How much value do you expect each player to capture? d. Which strategic position is the best in this market? (Hint: Laura Needham, Stern MBA 2008, suggested the term “The Goldilocks Principle of Business Strategy” for what this question is designed to show)

25. Exercises on Added Value cont’d Q3: (Looks at still more general positioning) There are two firms, labeled F1 and F2, each of which can produce a single unit of a product. There are two suppliers, labeled S1 and S2, each of which can supply at most one firm. There are two buyers, labeled B1 and B2, each interested in buying at most one unit. Supplier S1 has a supplier cost of $5 of supplying F1, and $1 of supplying F2. Supplier S2 has a supplier cost of $7 of supplying F1 and $2 of supplying F2. Buyer B1 has a willingness-to-pay of $8 for F1’s product, and a willingness-to-pay of $6 for F2’s product. Buyer B2 has a willingness-to-pay of $4 for F1’s product, and a willingness-to-pay of $3 for F2’s product. a. Which is the high-quality firm? Which is the lower-cost firm? b. What are the added values of the two firms? c. Which firm has the better strategic position?

26. Exercises on Added Value cont’d Q4: (Looks at the idea of a “branded-ingredient” strategy) There are two firms that can each produce a single unit of a product. There is one supplier, which can supply at most one of the firms at an opportunity cost of $4. There are numerous buyers, each of which would like to buy a single unit of the product from one of the two firms. The buyers have a willingness-to-pay of $10 for firm A’s product, and a willingness-to-pay of $6 for firm B’s product. a. What is the added value of each player? b. How much value do you expect the supplier to capture? How much do you expect firm A to capture? Now suppose that firm B can increase the buyers’ willingness-to-pay for its product to $9 by spending $1 prior to the game. (For an example, think of the supplier as Intel, firm A as Dell, and firm B as a generic PC assembler. The idea is that the generic firm might be able to make investments in product development or advertising that increase willingness-to-pay for its product.) c. Should firm B make this investment in increasing its willingness-to-pay? d. Should the supplier help fund this investment?