Transcript 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?
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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…..
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8 Firms
4 Markets
3 Choices
9 Periods
Each class plays two separate games
Firms
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8 teams with 3-4 players
Each firm has a set of distinct “capabilities”
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Costs of entering a market, building capacity, and
marginal costs of production
Each firm has a million dollars and access to
external financing
Markets
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4 separate markets with distinct supply and
demand differences
Supply
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Different distributions of costs across firms
Demand
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Different market sizes
Different types of “tastes” across markets
Choices & Periods
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Each period a firm makes three choices in
each of the four markets
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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
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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…
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How much you sold
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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…
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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
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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
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
1
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…
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Period 1: Enter into one market and choose
capacity
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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
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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
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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
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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?
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You have 3 pieces of information:
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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
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Entry cost (EC): one-time sunk cost to enter an
industry
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Capacity cost (K): cost paid per unit to build
capacity, which has 4 units of productive life
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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)
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
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“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?
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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…)
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Example: Market B and fictional “Team 501”
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Mean EC=50,000, SD=3,000
Mean K=20, SD=4
Mean MC=220, SD=40
Team 501 EC=52,541
Team 501 K=8
Team 501 MC=212
Question: Is Team 501 well positioned in Market B?
Be careful!
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Costs are distributed normally, but with only 8 cost
draws in any game, anything is possible!
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Normality only holds with LOTS of draws
Example from last year’s game: capacity costs in
market D (capital intensive market)
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Mean K=$1,600; SD=400
Actual team draws:
1.
2.
3.
4.
5.
6.
7.
8.
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
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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)
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Market economics look VERY different depending on levels of EC, K, MC
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Total revenue (assuming constant price):
 N * 8 * price (for all periods) + capacity scrap costs (in periods 5 and 9)
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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!)
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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
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Market A: modest differentiation, moderate capital
requirements, moderate marginal costs
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Market B: low capital cost, high MC, differentiated
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Like business software (?)
Market D: high capital / sunk costs, low MC,
undifferentiated
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Like apparel (?)
Market C: moderate capital cost, low MC, highly
differentiated market
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Like refrigerators or other consumer durables (?)
Like memory chip production (?)
Analogies are not meant to be taken too seriously.
How can I start to think about demand
and pricing?
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Market demand and appropriate market prices are not as
intuitive as the cost side, so we’ve given you additional
information
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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)
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You can use this data to calculate what your company would
charge, and what capacity it would build, if it were a monopolist
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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
Market A Demand Curve
Linear Fit
R-squared=92%
Price
Price Quantity
157
4624
208
3187
168
4306
299
1430
331
1043
89
6927
441
311
300
1414
203
3361
213
3108
244
2356
359
807
399
485
188
3778
255
2212
281
1730
335
1096
350
857
175
4146
111
6254
500
450
400
350
300
250
200
150
100
50
0
0
1000
2000
3000
4000
Quantity
5000
6000
7000
8000
The P/Q relationship might not be linear
Market A Demand Curve
Exponential Fit
500
450
400
350
300
250
200
150
100
50
0
R2 = 0.9815
Price
Price
Market A Demand Curve
Polynomial Fit
0
1000
2000
3000
4000
Quantity
5000
6000
7000
8000
500
450
400
350
300
250
200
150
100
50
0
R2 = 0.993
0
1000
2000
3000
4000
5000
6000
7000
8000
Quantity
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
Regressing
P=a+b*ln(Q)
relationship
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.9931415
R Square
0.98633
Adjusted R Square
0.9855706
Standard Error
11.532812
Observations20
20
10
0
-10
-20
-30
ANOVA
df
Regression 1
Residual
18
Total
19
SS
172742
2394.1
175136
MS
F
Significance F
172742 1298.8 3E-18
133.01
Coefficients SE
t Stat
P-value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
1104.1011 23.6935 46.599 3E-20 1054 1154 1054 1153.88
X Variable 1 -111.72244 3.10011 -36.038 3E-18 -118 -105 -118 -105.209
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.
0
Leading to easy calculation of monopoly price
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Our functional form assumption was P=a+b*ln(Q)
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In our regression estimate, a=1104, b=-111.7
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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
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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
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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
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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?
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What are the problems with this?
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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)
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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
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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
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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
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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
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In each round, you’ll get important pieces of information
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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
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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
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Using public statements to collude will result in SEC fines
Mentions of suggested pricing or capacities strictly not allowed
How you are evaluated
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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
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Previous students have suggested adding a real financial
element to the game to help incentives and make the game
even more fun
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Note: participation is voluntary – if your team doesn’t want to
play for money, let your professor know; it won’t affect your
grade
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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
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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
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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)