filename: where-do-payoffs-come-from-added-value-short-01-02-10

Where Do Payoffs Come From?

In a business context, we think of each pair of choices (entry, position, capacity, ) as leading to a game of bargaining among the players (firms, suppliers, and buyers)
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5, 1996, 5-24 An Introduction to Business-Centered Economics, by Scott Borg, Adam Brandenburger, and Harborne Stuart, unpublished,1996 Biform Games, by Adam Brandenburger and Harborne Stuart, Management Science, 53, 2007, 537549

Or in the Tree

A Game Tree of Bargaining?

Complexity

Game
Tic-Tac-Toe Checkers Chess Go

Size of Tree
(as log to base 10)* 5 31 123 360

Pictures: Wikimedia Commons

* Estimates from http://en.wikipedia.org/wiki/Game_tree_complexity

An Alternative Approach: Added Value

Do not attempt to describe how the game is played

Instead, delimit possible outcomes of the game

State a principle delimiting how much value each player can get

The Added-Value Principle

The DEFINITION: For each player i, the ADDED VALUE of player i =

Total pie with player i in the game

Total pie without player i in the game

The PRINCIPLE: Simultaneously, for each player i,

Slice to player i

player is added value

The Argument Behind the Principle

Suppose, for some player i,

Slice to player i

> player is added value

That is:
Slice to player i Total pie with player i in the game

>

Total pie without player i in the game

The Argument contd

Rewriting:

Sum of slices to other players

Slice to player i

>

+
Slice to player i

Total pie without player i in the game

Rearranging:
Sum of slices to other players
Total pie without player i in the game

>

<

The Argument contd

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
There is nothing to take if you have nothing to offer. -- Demosthenes, 4th century B.C. 10

A Card Game

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

Picture: Wikimedia Commons

How do you expect the negotiations to proceed?

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From: Co-opetition, by Adam Brandenburger and Barry Nalebuff, Doubleday, 1996

A Card Game contd

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

Picture: Wikimedia Commons

How do you expect the negotiations to proceed this time?

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From: Co-opetition, by Adam Brandenburger and Barry Nalebuff, Doubleday, 1996

Added Values in the Card Game

First version: Adams added value =

Each students added value =

Second version: Adams added value = Each students added value = A variant of the second versionin which 5 students form a coalition: Adams added value =

The coalitions added value =

Each remaining students added value = Other calculations
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Examples of Undersupply
The [NFL] league likes to leave one prominent city without a football franchise, like an empty seat in musical chairs*

Pictures: Wikimedia Commons

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 wont have to pay. **
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* John Vrooman, Vanderbilt University, in In a League of Its Own, The Economist, 04/27/06 ** Winners Lose in Olympic Bid, by Gordon T. Anderson, cnnmoney.com, 07/05/05

Undersupply: Size as Well as Division of the Pie

Its a tough balancing act. The rich dont want to wait, but if you have a product you dont have to wait for it isnt exclusive, and nobody wants it. Ferraris 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 overestimated the appeal of the McLaren SLR, and built too many and now dealers cant 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 well 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 15

Maserati S.p.A. lgo

Undersupply contd

[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

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Picture: Wikipedia

Now What Exactly is the Pie (aka the Total Value Created)?

Customers

Who are Googles customers? Who are a charitys customers?

Business

Non-material resources: Human, Capital, Information,

Suppliers
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Note: Value Chains can have additional linkse.g., from business to distributor, or from to retailer to end-user

Who is a Customer contd

In an effort to coax more money out of top givers, charities are increasingly turning to extreme travel as a fund-raising tacticsending donors where their money is. They want to see itthe 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 sayand eventually yield more money. *

http://www.bridgespan.org/

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* Have Donation, Will Travel, by Katherine Rosman, WSJ, 10/01/04

Who is a Customer contd

Berlin-based publisher Springer is buying BioMed Central (BMC), the worlds largest publisher of open-access journals. Launched in 2002 by entrepreneur Vitek Tracz, 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. *

http://www.biomedcentral.com/

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* Free Gets Sold, by Jocelyn Kaiser, Science, 10/17/08, p.359

Definition of the Pie (aka the Value Created)

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 circularhow to proceed?

Willingness-to-pay (W2P) is the ceiling

Supplier cost (SC) is the floor

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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

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Determining W2P and SC

Quantitative calculation Industrial equipment

W2P

Qualitative assessment Consumer product

SC

Quantitative calculation Opportunity cost of capital Qualitative assessment Job opportunities

We will look at both quantitative and qualitative assessments

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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 firms 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 Bs or firm Cs 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 As product. (Think of this situation as one in which firm A can pursue a Porter-style differentiation strategy by using a higher quality inputwhich has a higher supplier costto 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 Based on Exercises on Added Value, teaching material, 12/10/07, by Adam Brandenburger, Ken Corts, and Harborne Stuart, 23 and game. The Supplier -Firm-Buyer Game and Itsyou M-sided Generalization, Stuart, Mathematical Social the12/10/07; second Which game do expect firm by A Harborne to choose? Sciences, 34, 1997, 21-27

Exercises on Added Value contd

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 As product, a willingness-to-pay of $12 for firm Bs product, and a willingness-to-pay of $13 for firm Cs 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)

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Exercises on Added Value contd

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 F1s product, and a willingness-to-pay of $6 for F2s product. Buyer B2 has a willingness-to-pay of $4 for F1s product, and a willingness-to-pay of $3 for F2s 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?

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Exercises on Added Value contd

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 As product, and a willingness-to-pay of $6 for firm Bs 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?

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