Adopting game theory to understand the incumbent in an industry

In business as in war, understanding your enemy is critically important. When looking to launch into a new industry, you’ll want to understand your competitors capabilities, weaknesses, goals, economic strategy and non-economic strategy.

Only through a thorough understanding of the incumbent’s position,  can you determine their likely recourse, should you enter the industry.

Game theory studies human and corporate interaction, cooperation and conflict reactions when the parties are put in a competitive environment.

In game theory, we have:

  • Zero-sum games – which is where one companies gain is the other companies loss. So, if one party gains £100 the other party will lose exactly £100, leading to a sum of zero.
  • Non-zero sum games is where the sum of the gains and losses between the two players can be more or less than zero (e.g. the prisoners dilemma).

How can I analyse my competitor?

First and foremost, it’s important to analyse the executives of the incumbent. If you can find out where they’ve worked before, past success, past failures and their education, you can build a well rounded profile of the executive and make a reasoned judgement about the kind of action they are likely to take.

You’ll also need to understand the economic incentives of the rival. You can do this through a cost / benefit analysis. I.e. if the competitor is to launch a price war against you, to push you back out of the industry, what does that look like to them at a financial level. The cost is clearly added marketing spend & slimmer profit margins. The benefit is that they may not lose so much market share and may even build their customer base.  If you can accurately determine whether those benefits outweigh the costs, then you can conclude their likely action.

Of course, you also need to understand the organisational goals. If their goal is to provide industry leading returns for their investors, perhaps they can’t afford to reduce their profit margins, perhaps the shareholders will have sway on this matter. If so, a price war may seem less likely.

You must be careful with your analysis. It may be the case that you review your competitors finances and make the judgement that exiting the industry would make sound business sense. However, that supplier may be in the sunken cost trap, we we discussed in a previous article. This is where the incumbent has invested in the ‘wrong’ technology. However, as they’ve invested so much time, effort and capital into the technology, they have an emotional, irrational attachment to it.  So even when we think a competitor should exit the industry,  they may not. They may throw more good money after bad in an attempt to make their business decision work for them.

Political factors may also impact a companies decision to exit an industry. In France for example, there are strict rules about the downsizing of organisations, to protect the workforce. As such, we may view that the most sensible option is for them to exit the industry, but political factors may impact that decision.

All of the above requires reasoned judgement. Given your expectation of what they will do,  you can formulate a strategy that you believe is right for your business.We call this Game Theory.

What can the incumbent do?

The incumbent has two major options. They may, if their situation can accommodate it, spend lots of money on marketing and drive prices down to crush the new entrant.

Alternatively, they may adopt an accommodation strategy. That is, if they think that you are a niche player and won’t take much of their market share, they may retain their cost model and forego a small amount of market share.

If the incumbent decides that they should fight the new start up, they have options within that. They could attack the start up aggressively. This would do two things, it would halt the growth of that start up and it would also set a precedent for other entrepreneurs entering the market. If they know they’re going to met with aggression, it may stop new competition.

There is also the opportunity to market aggressively to the customers they think are most likely to defect to the new competitor. This is something that was adopted by British Airways when Ryan Air started flying the London / Dublin route. They identified the customers that were most price sensitive and sent them customised deals. Those customers that were less price sensitive still paid the full price.

The incumbent can also launch a preemptive attack. An example of this is when Proctor and Gamble were trying to launch a bleach product in a market dominated by Clorox.  They decided to test their product in a single town in America, using coupons to drive customer purchases. Clorox heard about P&G’s plan and launched a preemptive attack. They left one gallon of bleach on every doorstep in the town, rendering P&Gs coupon campaign useless.  Due to this, P&G knew that Clorox would fight very aggressively to keep their market share.  So they didn’t enter the market.

How can I use game theory to determine my actions?

Game theory uses the concept of looking forward and reason backward. So, you determine what you believe the incumbent will do and you use that to determine what you should do.

A famous example of this is the Blockbuster / Netflix industry shift.

When Netflix arrived with a new pricing model which included zero late fees, Blockbuster had a decision to make. Should they retain their late fees or drop them so that they could compete with Netflix.

Netflix looked at the economic motives of Blockbuster.  They noticed that the company was generating 300 million dollars a year from late fees.  Their operating profit was dependent on late fees. To stop charging those fees, would render the business unprofitable.

So, when Netflix entered the market, they were confident that Blockbuster would not fight aggressively on price, by removing their late fees. They were correct.

The executives at Blockbuster had concluded that Netflix was a niche player and that they wouldn’t grow quickly. They therefore decided to forego a small chunk of market share, while retaining the profitability of their business.

Netflix used game theory to preempt the actions of the incumbent and used that judgement to steer their own decisions.

Failure to use Game Theory

Now let’s talk about a time that game theory was not applied and the company subsequently failed.

Nutrasweet make artificial sweeteners. They provide major players Coke and Pepsi with sweetener for their products.

A number of years ago, the Nutrasweet patents were set to expire. As such, new players were looking to the market for opportunities.

One such player make the mistake of not fully understanding their rivals. They didn’t fully appreciate the economies of scale or the cost savings as a result of the learning curve that Nutrasweet had at their disposal.

Because they didn’t understand this, they didn’t know that Nutrasweet could drop their price dramatically and still make profit.  Remember, this is a commodity product, other than price, there is no way to differentiate between brands.

Not fully understanding their competitor, led to their businesses demise as they simply couldn’t compete.

Summary

Understanding what the incumbent may do if you launch into their market is critical for success. To understand what they may do, you need to first understand your own business. Are you launching a nice product within an industry or are you targeting the exact customer base of the incumbent? Clearly, this will impact the way they react dramatically.

Also, you need to understand the market. Is it a slow growth market? If yes, the incumbent will struggle to replace their existing customer base with new customers. So, they’ll certainly fight harder to keep the ones they have.

If you’re launching a commodity product, then price is really the only weapon that the incumbent has against you. By analysing their economic and non-economic situation, you can determine whether they’re likely to enter a price war with you.

If the competitor has high fixed costs and low variable costs, like players in the airline industry, then they are far more likely to drop their prices to compete with you. As filling a plane with 1 or 100 people, doesn’t make much difference to their costs but can dramatically impact their profits.

Understanding the people leading the organisation and their reaction to new entrants in the past, will help you to determine their likely course of action. Of course, not everyone is rational, which can lead to a disconnect between what you believe they should do and what actually happens, but hopefully you can identify any past irrational actions and use them to guide your decision.

Finally, if the competitor can target their fight, that is, offer discounts to the customers most likely to defect to your business, then they are far more likely to fight you. If they must take a hit to their revenue across the board to fight, they are more likely to stand firm with their pricing strategy.

Thorough analysis leads to successful startup launches.