WHERE DO PAYOFFS COME FROM?ADDED VALUE

Adam Brandenburger

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

Where Do Payoffs Come From?

D

Ann

L R

Bob

U

2

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unpublished,1996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

Ann

BobBob

U D

L L*R R*

Or in the Tree …

3

A Game Tree of Bargaining?

…

……

……

……

……

……

……

……

…

4

Game Size of Tree(as log to base 10)*

Tic-Tac-Toe 5

Checkers 31

Chess 123

Go 360

Complexity

* Estimates from http://en.wikipedia.org/wiki/Game_tree_complexity5Pictures: Wikimedia Commons

An Alternative Approach: Added Value

6

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

Total piewith

player i inthe game

Total piewith

player i inthe game

Total piewithout

player i in the game

Total piewithout

player i in the game

The Added-Value Principle

≤ player i’s added value

7

_

The PRINCIPLE:Simultaneously, for each player i, Slice

toplayer i

The Argument Behind the Principle

> player i’s added valueSuppose, for some player i,

That is:

Total piewith

player i inthe game

Total piewith

player i inthe game

Total piewithout

player i in the game

Total piewithout

player i in the game

_>

Sliceto

player i

Sliceto

player i

8

The Argument cont’d

Rewriting:

Total piewithout

player i in the game

Total piewithout

player i in the game

_> Slice

toplayer i

Sum of slices to other players

+

Sliceto

player i

Rearranging:

Total piewithout

player i in the game

Total piewithout

player i in the game

>

Sum of slices to other players <

9

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

10

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

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

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

Picture: Wikimedia Commons

A Card Game

11

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

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

Picture: Wikimedia Commons

A Card Game cont’d

12

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 …

13

Examples of Undersupply …

“The [NFL] league likes to leave one prominent city without a football franchise, like an empty seat in musical chairs”*

“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.” **

* 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, 07/05/0514

Pictures: Wikimedia Commons

Undersupply: Size as Well as Division of the Pie

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

Maserati S.p.A. lgo

Undersupply cont’d

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

Picture: Wikipedia

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

MonetaryFlow

Resources/Inputs

Products/Outputs

Note: Value Chains can have additional links—e.g., from business to distributor, or from to retailer to end-user

Suppliers

Business

Customers

“Non-material” resources: Human, Capital, Information, …

Who are Google’s customers?Who are a charity’s customers?

17

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

* “Have Donation, Will Travel,” by Katherine Rosman, WSJ, 10/01/0418

http://www.bridgespan.org/

Who is a Customer cont’d

* “‘Free’ Gets Sold,” by Jocelyn Kaiser, Science, 10/17/08, p.35919

Berlin-based publisher Springer is buying BioMed Central (BMC), the world’s 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/

Customer

Definition of the Pie (aka the Value Created)

Supplier

Receive product and give $s

Give resource and receive $s

Status quo

Status quo

Willingness-to-pay (“W2P”) is the ceiling

Supplier cost (“SC”) is the floor

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?

Willingness-to-pay

Supplier cost

Price

Cost

$

Value received by customer

Value received by business

Value received by supplier

The Pie (aka the Value Created) = W2P – SC

Finally … the Pie

21

Determining W2P and SC

W2P

•Quantitative calculationIndustrial

equipment

•Qualitative assessmentConsumer

product

SC

•Quantitative calculationOpportunity cost of

capital

•Qualitative assessmentJob

opportunities

22

We will look at both quantitative and qualitative assessments

Exercises on Added Value

23

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

Exercises on Added Value cont’d

24

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)

Exercises on Added Value cont’d

25

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?

Exercises on Added Value cont’d

26

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?