Tag: Strategy

What Matters More in Decisions: Analysis or Process?

We all make decisions. Some of them are large and many of them are small. Few of us understand that the process we use to make those decisions is more important than the analysis we put into the decision.

 

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Think of the last major decision you made.

Maybe it was an acquisition, a large purchase, or perhaps it was whether to launch a new product.

Odds are three things went into that decision: (1) It probably relied on the insights of a few key executives; (2) it involved some sort of fact gathering and analysis; and (3) it was likely enveloped in some sort of decision process—whether formal or informal—that translated the analysis into a decision.

Now how would you rate the quality of your organization’s strategic decisions?

If you’re like most executives, the answer wouldn’t be positive:

In a recent McKinsey Quarterly survey of 2,207 executives, only 28 percent said that the quality of strategic decisions in their companies was generally good, 60 percent thought that bad decisions were about as frequent as good ones, and the remaining 12 percent thought good decisions were altogether infrequent.

How could it be otherwise? Product launches are frequently behind schedule and over budget. Strategic plans often ignore even the anticipated response of competitors. Mergers routinely fail to live up to the promises made in press releases.

The persistence of problems across time and organizations, both large and small, indicates that we can make better decisions.

“I have no use whatsoever for projections or forecasts. They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be. We never look at projections.”

— Warren Buffett

The best place to start if we’re trying to improve the quality of our decisions is to look at how organizations make decisions. One interesting thing about bureaucracies is that they develop processes to limit the damage the worst people can do at every level. That is they come up with mechanisms to reduce the impact the worst people can have. Yes, this also limits the positive impact that people can have as well. When it comes to decisions, organizations default to gathering data and analyzing decisions.

The widespread belief is that analysis reduces biases. But does it?

Is putting your faith in analysis any better than using your gut? What does the evidence say? Is there a better way?

Dan Lovallo and Olivier Sibony set to find out.

Lovallo is a professor at the University of Sydney and Olivier is a director at McKinsey & Company. Together they studied 1,048 “major” business decisions over five years. The results are surprising.

Most business decisions were not made on “gut calls” but rather rigorous analysis. And yet they were poor decisions. In short, most people did the all the legwork we think we’re supposed to do: they delivered large quantities of detailed analysis.

Yet this wasn’t enough. “Our research indicates that, contrary to what one might assume, good analysis in the hands of managers who have good judgment won’t naturally yield good decisions.

[Projections] are put together by people who have an interest in a particular outcome, have a subconscious bias, and its apparent precision makes it fallacious. They remind me of Mark Twain’s saying, ‘A mine is a hole in the ground owned by a liar.’ Projections in America are often a lie, although not an intentional one, but the worst kind because the forecaster often believes them himself.”

— Charlie Munger

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Lovallo and Sibony didn’t only look at the analysis, they also asked executives about the process used to make decisions.

Did they, for example, “explicitly explore and discuss major uncertainties or discuss viewpoints that contradicted the senior leader’s?

So what matters more, process or analysis? After comparing the results they determined that “process mattered more than analysis—by a factor of six.

This finding does not mean that analysis is unimportant, as a closer look at the data reveals: almost no decisions in our sample made through a very strong process were backed by very poor analysis. Why? Because one of the things an unbiased decision-making process will do is ferret out poor analysis. The reverse is not true; superb analysis is useless unless the decision process gives it a fair hearing.

To illustrate the weakness of how most organizations make decisions, Sibony used an interesting analogy: the legal system.

Imagine walking into a courtroom where the trial consists of a prosecutor presenting PowerPoint slides. In 20 pretty compelling charts, he demonstrates why the defendant is guilty. The judge then challenges some of the facts of the presentation, but the prosecutor has a good answer to every objection. So the judge decides, and the accused man is sentenced.

That wouldn’t be due process, right? So if you would find this process shocking in a courtroom, why is it acceptable when you make an investment decision? Now of course, this is an oversimplification, but this process is essentially the one most companies follow to make a decision. They have a team arguing only one side of the case. The team has a choice of what points it wants to make and what way it wants to make them. And it falls to the final decision maker to be both the challenger and the ultimate judge. Building a good decision-making process is largely ensuring that these flaws don’t happen.

Simply understanding our cognitive biases doesn’t make you immune to them. It’s not enough.  A disciplined decision process is the best place to improve the quality of decisions and guard against common decision-making biases.

Still curious? Read the ultimate guide to making smart decisions.

Footnotes
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    The inspiration for this post comes from Chip and Dan Heath in Decisive.

Henry Singleton on Strategic Planning — Stay Flexible

Henry Singleton

Henry Singleton has the best operating and capital deployment record in American business . .  . if one took the 100 top business school graduates and made a composite of their triumphs, their record would not be as good as Singleton’s. —Warren Buffett, 1980

Henry Singleton eschewed detailed strategic plans, preferring to remain flexible.

“I know a lot of people have very strong and definite plans that they’ve worked out on all kinds of things, but we’re subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible.”

In a rare interview with a BusinessWeek reporter, he explained himself more simply:

My only plan is to keep coming to work. … I like to steer the boat each day rather than plan ahead way into the future.

Henry Singleton as quoted in The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success

Still curious? If you want to learn more about Singleton read the excellent Distant Force: A Memoir of the Teledyne Corporation and the Man Who Created It. You can learn more about strategy here.

Mental Model: Game Theory

Game Theory

From Game Theory, by Morton Davis:

The theory of games is a theory of decision making. It considers how one should make decisions and to a lesser extent, how one does make them. You make a number of decisions every day. Some involve deep thought, while others are almost automatic. Your decisions are linked to your goals—if you know the consequences of each of your options, the solution is easy. Decide where you want to be and choose the path that takes you there. When you enter an elevator with a particular floor in mind (your goal), you push the button (one of your choices) that corresponds to your floor. Building a bridge involves more complex decisions but, to a competent engineer, is no different in principle. The engineer calculates the greatest load the bridge is expected to bear and designs a bridge to withstand it. When chance plays a role, however, decisions are harder to make. … Game theory was designed as a decision-making tool to be used in more complex situations, situations in which chance and your choice are not the only factors operating. … (Game theory problems) differ from the problems described earlier—building a bridge and installing telephones—in one essential respect: While decision makers are trying to manipulate their environment, their environment is trying to manipulate them. A store owner who lowers her price to gain a larger share of the market must know that her competitors will react in kind. … Because everyone’s strategy affects the outcome, a player must worry about what everyone else does and knows that everyone else is worrying about him or her.

What is a game? From Game Theory and Strategy:

Game theory is the logical analysis of situations of conflict and cooperation. More specifically, a game is defined to be any situation in which:

  1. There are at least two players. A player may be an individual, but it may also be a more general entity like a company, a nation, or even a biological species.
  2. Each player has a number of possible strategies, courses of action which he or she may choose to follow.
  3. The strategies chosen by each player determine the outcome of the game.
  4. Associated to each possible outcome of the game is a collection of numerical payoffs, one to each player. These payoffs represent the value of the outcome to the different players.

…Game theory is the study of how players should rationally play games. Each player would like the game to end in an outcome which gives him as large a payoff as possible.

From Greg Mankiw’s Economics textbook:

Game theory is the study of how people behave in strategic situations. By ‘strategic’ we mane a situation in which each person, when deciding what actions to take, must consider how others might respond to that action. Because the number of firms in an oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce. In making its production decision, each firm in an oligopoly should consider how its decision might affect the production decisions of all other firms.

Game theory is not necessary for understanding competitive or monopoly markets. In a competitive market, each firm is so small compared to the market that strategic interactions with other firms are not important. In a monopolized market, strategic interactions are absent because the market has only one firm. But, as we will see, game theory is quite useful for understanding the behavior of oligopolies.

A particularly important ‘game’ is called the prisoners’ dilemma.

Markets with only a few sellers

Because an oligopolistic market has only a small group of sellers, a key feature of oligopoly is the tension between cooperation and self-interest. The oligopolists are best off when they cooperate and act like a monopolist – producing a small quantity of output and charging a price above marginal cost. Yet because each oligopolist cares only about its own profit, there are powerful incentives at work that hinder a group of firms from maintaining the cooperative outcome.

Avinash Dixit and Barry Nalebuff, in their book “Thinking Strategically” offer:

Everyone’s best choice depends on what others are going to do, whether it’s going to war or maneuvering in a traffic jam.

These situations, in which people’s choices depend on the behavior or the choices of other people, are the ones that usually don’t permit any simple summation. Rather we have to look at the system of interaction.

Michael J. Mauboussin relates game theory to firm interaction

How a firm interacts with other firms plays an important role in shaping sustainable value creation. Here we not only consider how many companies interact with their competitors, but how companies can co-evolve.

Game Theory is one of the best tools to understand interaction. Game Theory forces managers to put themselves in the shoes of other players rather than viewing games solely from their own perspective.

The classic two-player example of game theory is the prisoners’ dilemma.

Game Theory is part of the Farnam Street latticework of Mental Models. See all posts on game theory.

Your Strategy Is Not What You Say It Is — Clayton Christensen

If you study the root causes of business disasters and management missteps, you’ll often find a predisposition toward endeavors that offer immediate gratification. Many companies’ decision-making systems are designed to steer investments to initiatives that offer the most tangible returns, so companies often favor these and short-change investments in initiatives that are crucial to their long-term strategies.

In the words of Andy Grove, former chairman and chief executive officer of Intel: “To understand a company’s strategy, look at what they actually do rather than what they say they will do.” Real strategy—in companies and in our lives—is created through hundreds of everyday decisions about where we spend our resources. But as you’re living your life from day to day, how do you make sure you’re heading in the right direction?

Here is a way to frame the investments we make in the strategy that becomes our lives: We have resources—which include personal time, energy, talent, and wealth—and we are using them to try to expand several “businesses” in our personal lives. These include having a rewarding relationship with our spouse or significant other; succeeding in our careers; and so on. Unfortunately, our resources are limited, and these “businesses” are competing for them.

It’s exactly the same problem that a corporation has. Your resources are not decided and deployed in a single meeting; instead, the process is continuous, and you have, in your brain, a filter for making choices about what to prioritize.

Clayton Christensen, How Will You Measure Your Life

But it’s also a messy process. People ask for your time and energy every day and even if you are focused on what’s important to you, it’s still difficult to know which are the right choices. If you have an extra ounce of energy or a spare 30 minutes, a lot of people will push you to spend them here rather than there. With so many people and projects wanting your time and attention, you can feel like you are not in charge of your own destiny.

The danger for high-achieving people is that they’ll unconsciously allocate their resources to activities that yield the most immediate, tangible accomplishments. This is often in their careers, as this domain of their lives provides the most concrete evidence that they are moving forward. They ship a product, finish a design, help an employee, close a sale, teach a class, win a case, publish a paper, get paid, get promoted. They prioritize tasks that give them immediate returns—such as a promotion, a raise, or a bonus—rather than those that require long-term work.

Although they may believe their family is deeply important to them, they actually allocate fewer and fewer resources to the things they would say matter most.

Few people set out to do this. The decisions that cause it to happen often seem tactical, just small decisions they think won’t have any larger impact. But as they keep allocating resources in this way—and although they often won’t realize it—they’re implementing a strategy vastly different from what they intend.

Bottom line: If the decisions you make about where you invest your blood, sweat, and tears are not consistent with the person you aspire to be, you’ll never become that person. As you continue on your life’s journey, allocate your resources wisely—at work and home.

Still curious? Read How Will You Measure Your Life.

Source: Adapted from How Will You Measure Your Life? by Clayton M. Christensen, James Allworth, and Karen Dillon.

A Primer on Strategy

Good-Strategy-Bad-Strategy

There are many good reasons to read Good Strategy Bad Strategy by Richard Rumelt.

You may be frustrated by the state of your organization’s strategy. You may be interested in identifying the characteristics of good strategy. Or you may want to learn how to identify the elements of a bad strategy.

A leader’s most important responsibility is identifying the biggest challenges to forward progress and devising a coherent approach to overcoming them. In contexts ranging from corporate direction to national security, strategy matters. Yet we have become so accustomed to strategy as exhortation that we hardly blink an eye when a leader spouts slogans and announces high-sounding goals, calling the mixture a “strategy.”

Complexity

“A hallmark of mediocrity and bad strategy,” Rumelt writes, “is unnecessary complexity—a flurry of fluff masking an absence of substance.” Most bad strategies are nothing more than statements of desire. And if you read them closely, the goals often contradict one another.

This book should be required reading for managers and executives alike.

The Strategy Retreat

I’m sure this excerpt sounds familiar to many of you:

The event was a “strategy retreat.” The CEO had modeled it on a similar event at British Airways he had attended several years before. About two hundred upper-level managers from around the world gathered in a hotel ballroom where top management presented a vision for the future: to be the most respected and successful company in their field. There was a specially produced motion picture featuring the firm’s products and services being used in colorful settings around the world. There was an address by the CEO accompanied by dramatic music to highlight the company’s “strategic” goals: global leadership, growth, and high shareholder return. There were breakouts into smaller groups to allow discussion and buy-in. There was a colorful release of balloons. There was everything but strategy.

Good strategy is the exception not the rule. Rumelt argues that the bad strategy problem is only growing. Even worse, more and more leaders think they have a strategy when they do not—they have a bad strategy. Bad strategy, “ignores the power of choice and focus, trying instead to accommodate a multitude of conflicting demands and interests.” Sounds familiar?

What is a bad strategy?

Bad strategy is long on goals and short on policy or action. It assumes that goals are all you need. It puts forward strategic objectives that are incoherent and, sometimes, totally impracticable. It uses high-sounding words and phrases to hide these failings.

Underperformance is a result

When a leader characterizes the challenge as underperformance, it sets the stage for bad strategy. Underperformance is a result. The true challenges are the reasons for the underperformance.

Good Strategy

Good strategy is not just “what” you are trying to do. It is also “why” and “how” you are doing it. … Good strategy requires leaders who are willing and able to say no to a wide variety of actions and interests. Strategy is at least as much about what an organization does not do as it is about what it does.

Strategy is not vision or ambition

Despite the roar of voices wanting to equate strategy with ambition, leadership, “vision,” planning, or the economic logic of competition, strategy is none of these. The core of strategy work is always the same: discovering the critical factors in a situation and designing a way of coordinating and focusing actions to deal with those factors. A leader’s most important responsibility is identifying the biggest challenges to forward progress and devising a coherent approach to overcoming them. In contexts ranging from corporate direction to national security, strategy matters.

The core of strategy has three elements:

The kernel of a strategy contains three elements: a diagnosis, a guiding policy, and coherent action. The guiding policy specifies the approach to dealing with the obstacles called out in the diagnosis. It is like a signpost, marking the direction forward but not defining the details of the trip. Coherent actions are feasible coordinated policies, resource commitments, and actions designed to carry out the guiding policy.

Coherence of design

A good strategy doesn’t just draw on existing strength; it creates strength through the coherence of its design. Most organizations of any size don’t do this. Rather, they pursue multiple objectives that are unconnected with one another or, worse, that conflict with one another.

Coordination is costly and hard.

Coordination is costly, because it fights against the gains to specialization, the most basic economies in organized activity. To specialize in something is, roughly speaking, to be left alone to do just that thing and not be bothered with other tasks, interruptions, and other agents’ agendas. As is clear to anyone who has belonged to a coordinating committee, coordination interrupts and de-specializes people.

Good strategy is actually surprising.

Most complex organizations spread rather than concentrate resources, acting to placate and pay off internal and external interests. Thus, we are surprised when a complex organization, such as Apple or the U.S. Army, actually focuses its actions. Not because of secrecy, but because good strategy itself is unexpected.

Focus, however, is hard. It means saying no to individuals, groups, and even entire lines of business.

The inside view describes the fact that people tend to see themselves, their group, their project, their company, or their nation as special and different.

Increasing value …

In particular, increasing value requires a strategy for progress on at least one of four different fronts: deepening advantages, broadening the extent of advantages, creating higher demand for advantaged products or services, or strengthening the isolating mechanisms that block easy replication and imitation by competitors.

Unfinished Thought

As I was reading this book I kept wondering why organizations were so reluctant to employ a strategy. All of this thinking reminded me of another book I had read a few years back on strategy called The Strategy Paradox.

What is the paradox?

The most profitable strategies are “extreme” strategies that commit companies to positions of either product differentiation or cost leadership. These extreme positions expose firms to a greater likelihood of bankruptcy by increasing the strategic risk they face. Consequently, the strategies likeliest to succeed are also likeliest to fail. That is the strategy paradox.

At first I thought that maybe organizations avoided good strategy simply because it was complicated and involved hard choices. The more I thought about it, however, the more I settled on the fact that people avoid good strategies because they don’t want to be wrong.

When Steve Jobs took over Apple, he did the unexpected.

What he did was both obvious and, at the same time, unexpected. He shrunk Apple to a scale and scope suitable to the reality of its being a niche producer in the highly competitive personal computer business. He cut Apple back to a core that could survive.

Steve Jobs talked Microsoft into investing $150 million in Apple, exploiting Bill Gates’s concerns about what a failed Apple would mean to Microsoft’s struggle with the Department of Justice. Jobs cut all of the desktop models—there were fifteen—back to one. He cut all portable and handheld models back to one laptop. He completely cut out all the printers and other peripherals. He cut development engineers. He cut software development. He cut distributors and cut out five of the company’s six national retailers. He cut out virtually all manufacturing, moving it offshore to Taiwan. With a simpler product line manufactured in Asia, he cut inventory by more than 80 percent. A new Web store sold Apple’s products directly to consumers, cutting out distributors and dealers.

What is remarkable about Jobs’s turnaround strategy for Apple was how much it was “Business 101” and yet how much of it was unanticipated.

In May 1998, shortly after taking over Apple, Jobs explained the substance and coherence of his actions:

The product lineup was too complicated and the company was bleeding cash. A friend of the family asked me which Apple computer she should buy. She couldn’t figure out the differences among them and I couldn’t give her clear guidance, either. I was appalled that there was no Apple consumer computer priced under $2,000. We are replacing all of those desktop computers with one, the Power Mac G3. We are dropping five of six national retailers—meeting their demand has meant too many models at too many price points and too much markup.

Jobs’s actions were both focused and decisive and, in hindsight, correct. Everyone at the time was surprised because they expected the fluffy goals and vacuous promises typical of most executives. But Jobs’s back-to-business 101 approach was correct. Jobs had a sick business and he needed to fix it.

While Jobs’s turnaround at Apple was impressive it wouldn’t enable Apple to become more than a niche player in an industry dominated by network effects. In 1998 Rumelt had a chance to ask Jobs “What is the strategy?” Jobs responded simply “I am going to wait for the next big thing.”

This encounter struck Rumelt as different. Everywhere he went and everyone he talked to just spewed the same clichés about their strategy — network relationships, adopt best practices, etc.

Rumelt writes:

Jobs did not enunciate some simple-minded growth or market share goal. He did not pretend that pushing on various levers would somehow magically restore Apple to market leadership in personal computers. Instead, he was actually focused on the sources of and barriers to success in his industry—recognizing the next window of opportunity, the next set of forces he could harness to his advantage, and then having the quickness and cleverness to pounce on it quickly like a perfect predator. There was no pretense that such windows opened every year or that one could force them open with incentives or management tricks. He knew how it worked. He had done it before with the Apple II and the Macintosh and then with Pixar. He had tried to force it with NeXT, and that had not gone well. It would be two years before he would make that leap again with the iPod and then online music. And, after that, with the iPhone.

Steve Jobs’s answer that day—“to wait for the next big thing”—is not a general formula for success. But it was a wise approach to Apple’s situation at that moment, in that industry, with so many new technologies seemingly just around the corner.

In hindsight we know Jobs’s strategy worked but it could have just as easily backfired. The turnaround might have failed and landed Apple, now the world’s largest company, in bankruptcy. Apple’s strategy at the time wasn’t easy to like — in fact, many people thought he was wrong. I imagine that Jobs would have been ok with being wrong — he was more worried about being mediocre.

We equate strategy with success but they are different things.

Real strategies—good strategies—can be wrong. And we don’t want to be wrong. We’re playing not to lose rather than playing to win. We all know how it feels to make a mistake — we’d rather watch other people make mistakes than make them ourselves. So we seek consensus because it’s safe.

Yet consensus, when you think about it, is almost assured to fail. It’s making everyone happy and alienating no one.

Consensus is the opposite of marshalling your resources towards a coordinated approach. And consensus, by definition, almost certainly assures a bad strategy because it doesn’t make any choices. It’s a sprinkle of this and a dash of that — it’s something for everyone. Rather than risk being wrong, we hide behind puff that makes everyone happy. That’s bad strategy.

The beauty of Good Strategy Bad Strategy is that it calls out the vast majority of public and private organizations that have horrible strategies. The bad news is that things are unlikely to change. After all, no one ever got fired for having a strategy to “increase the percentage of high school graduates.” It’s hard to argue with that as a goal but let’s stop calling it a strategy.

If you’re interested in learning more, watch this video of Richard Rumelt presenting at the London School of Economics:

There are plenty of good strategies out there. Lou Gestner developed one when he took over IBM in 1993 (for details see Gestner’s book — Who Says Elephants Can’t Dance?: Leading a Great Enterprise through Dramatic Change). He understood the problem and devised an approach that marshalled the organization towards dealing with the problem.

If you’re still curious, read the entire book.

Mental Model: Prisoners’ Dilemma

The prisoners’ dilemma is the best known strategy game in social science. The game shows why two entities might not cooperate even when it appears in their best (rational) interest to do so. What is rational for the individual in certain circumstances is not rational for the group — that is, pursuing a strategy that is rational for you leads to a worse outcome.

With applications to economics, politics, and business the game illustrates the conflict, which can sometimes arise, between individual and group rationality.

From Greg Mankiw’s Economics textbook:

The prisoners’ dilemma is a story about two criminals who have been captured by the police. Let’s call them Mr Black and Mr Pink. The police have enough evidence to convict Mr Black and Mr Pink of a relatively minor crime, illegal possession of a handgun, so that each would spend a year in jail. The police also suspect that the two criminals have committed a jewelery robbery together, but they lack hard evidence to convict them of this major crime. The police question Mr Black and Mr Pink in separate rooms, and they offer each of them the following deal:

Right now we can lock you up for 1 year. If you confess to the jewelery robbery and implicate your partner, however, we’ll give you immunity and you can go free. Your partner will get 20 years in jail. But if you both confess to the crime, we won’t need your testimony and we can avoid the cost of a trial, so you will each get an intermediate sentence of 8 years.

If Mr Black and Mr Pink, heartless criminals that they are, care only about their own sentences, what would you expect them to do? Would they confess or remain silent? Each prisoner has two strategies: confess or remain silent. The sentence each prisoner gets depends on the strategy chosen by his or her partner in crime.

Consider first Mr Black’s decision. He reasons as follows:

I don’t know what Mr Pink is going to do. If he remains silent, my best strategy is to confess, since then I’ll go free rather than spending a year in jail. If he confesses, my best strategy is still to confess, since then I’ll spend 8 years in jail rather than 20. So, regardless of what Mr Pink does, I am better off confessing.

In the language of game theory, a strategy is called a dominant strategy if it is the best strategy for a player to follow regardless of the strategies pursued by other players. In this case, confessing is a dominant strategy for Mr Black. He spends less time in jail if he confesses, regardless of whether Mr Pink confesses or remains silent.

Now consider Mr Pink’s decision. He faces exactly the same choices as Mr Black, and he reasons in much the same way. Regardless of what Mr Black does, Mr Pink can reduce his time in jail by confessing. In other words, confessing is a dominant strategy for Mr Pink.

In the end, both Mr Black and Mr Pink confess, and both spend 8 years in jail. Yet, from their standpoint, this is a terrible outcome. If they had both remained silent, both of them would have been better off, spending only 1 year in jail on the gun charge. By each pursuing his own interests, the two prisoners together reach an outcome that is worse for each of them.

To see how difficult it is to maintain cooperation, imagine that, before the police captured Mr Black and Mr Pink, the two criminals had made a pack not to confess. Clearly, this agreement would make them both better off if they both live up to it, because they would each spend only 1 year in jail. But would the two criminals in fact remain silent, simply because they had agreed to? Once they are being questioned separately, the logic of self-interest takes over and leads them to confess. Cooperation between the two prisoners is difficult to maintain because cooperation is individually irrational.

* * *

Michael J. Mauboussin writes:

The classic two-player example of game theory is the prisoners’ dilemma. We can recast the prisoners’ dilemma in a business context by considering a simple case of capacity addition. Say two competitors, A and B, are considering adding capacity. If competitor A adds capacity and B doesn’t, A gets an outsized payoff. Likewise, if B adds capacity and A doesn’t than B gets the large payoff. If neither expands, A and B aren’t as well-off as if one alone had added capacity. But if both add capacity, they’re worse off of than if they had done nothing.

* * *

Avinash Dixit offers:

Consider two firms, say Coca-Cola and Pepsi, selling similar products. Each must decide on a pricing strategy. They best exploit their joint market power when both charge a high price; each makes a profit of ten million dollars per month. If one sets a competitive low price, it wins a lot of customers away from the rival. Suppose its profit rises to twelve million dollars, and that of the rival falls to seven million. If both set low prices, the profit of each is nine million dollars. Here, the low-price strategy is akin to the prisoner’s confession, and the high-price akin to keeping silent. Call the former cheating, and the latter cooperation. Then cheating is each firm’s dominant strategy, but the result when both “cheat” is worse for each than that of both cooperating.

* * *

Warren Buffett provides some illumination as to how the Prisoners’ Dilemma plays out in business in the 1985 Berkshire Hathaway Annual report.

The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage. But that in no way means that our labor force deserves any blame for our closing. In fact, in comparison with employees of American industry generally, our workers were poorly paid, as has been the case throughout the textile business. In contract negotiations, union leaders and members were sensitive to our disadvantageous cost position and did not push for unrealistic wage increases or unproductive work practices. To the contrary, they tried just as hard as we did to keep us competitive. Even during our liquidation period they performed superbly. (Ironically, we would have been better off financially if our union had behaved unreasonably some years ago; we then would have recognized the impossible future that we faced, promptly closed down, and avoided significant future losses.)

Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industry-wide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers. I always thought myself in the position described by Woody Allen in one of his movies: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray we have the wisdom to choose correctly.”

For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.

Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington’s basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational.

Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 — on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.

This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise. The situation is suggestive of Samuel Johnson’s horse: “A horse that can count to ten is a remarkable horse – not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.

My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Some years ago I wrote: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.

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Mauboussin adds:

Our discussion so far has focused on competition. But thoughtful strategic analysis also recognizes the role of co-evolution, or cooperation, in business. Not all business relationships are conflictual. Sometimes companies outside the purview of a firm’s competitive set can heavily influence its value creation prospects.

Consider the example of DVD makers (software) and DVD player makers (hardware). These companies do not compete with one another. But the more DVD titles that are available, the more attractive it will be for a consumer to buy a DVD player and vice versa. Another example is the Wintel standard—added features on Microsoft’s operating system required more powerful Intel microprocessors, and more powerful microprocessors could support updated operating systems. Complementors make the added value pie bigger. Competitors fight over a fixed pie.

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Mankiw offers another real world example:

Consider an oligopoly with two members, called Iran and Saudi Arabia. Both countries sell crude oil. After prolonged negotiation, the countries agree to keep oil production low in order to keep the world price of oil high. After they agree on production levels, each country must decide whether to cooperate and live up to this agreement or to ignore it and produce at a higher level. The following image shows how the profits of the two countries depend on the strategies they choose.

Suppose you are the leader of Saudi Arabia. You might reason as follows:
I could keep production low as we agreed, or I could raise my production and sell more oil on world markets. If Iran lives up to the agreement and keeps its production low, then my country ears profit of $60 billion with high production and $50 billion with low production. In this case, Saudi Arabia is better off with high production. If Iran fails to live up to the agreement and produces at a high level, then my country earns $40 billion with high production and $30 billion with low production. Once again, Saudia Arabia is better off with high production. So, regardless of what Iran chooses to do, my country is better off reneging on our agreement and producing at a high level.

Producing at a high level is a dominant strategy for Saudi Arabia. Of course, Iran reasons in exactly the same way, and so both countries produce at a high level. The result is the inferior outcome (from both Iran and Saudi Arabia’s standpoint) with low profits in each country.

This example illustrates why oligopolies have trouble maintaining monopoly profits. The monopoly outcome is jointly rational for the oligopoly, but each oligopolist has an incentive to cheat. Just as self-interest drives the prisoners in the prisoners’ dilemma to confess, self-interest makes it difficult for the oligopoly to maintain the cooperative outcome with low production, high prices and monopoly prices.

Other examples of prisoners’ dilemma’s include: arms races, advertising, and common resources (see the Tradegy of the Commons)

The Prisoners’ Dilemma is part of the Farnam Street latticework of Mental Models.