Cooperative DecisionMaking

1
Cooperative Decision-Making

• How to identify opportunities for value creation
  and exploit them

2
Key Economic Skill

• Consider other players and put yourself in their
  shoes
• Two questions
• Do your actions affect their payoff?
• Do their actions affect your payoff?
• If the answer to either question is yes there
  is an opportunity to create value by cooperating

3
Neighbourhood Blues

• Todd values a quiet neighbourhood
• Lisa enjoys playing the saxophone
• They live next to one another
• Do Lisas actions affect Todds payoff?
• Is there a gain from cooperation (if Lisa has the
  legal right to play the saxophone)?

4
Answer Depends on Value

• Suppose that Lisa values playing the saxophone at
  100 while Todd values a quiet neighbourhood at
  150.
• Then if Todd were to pay Lisa 100 or more, then
  Lisa would choose not to play.
• What if Todd were legally entitled to silence?
  When would the outcome change?

5
The Coase Theorem

• The assignment of legal rights does not matter
  for the outcome. The efficient outcome will
  always be negotiated.
• However, rights do matter for the distribution of
  value.
• But what would happen if Lisa and Todd could not
  write an enforceable contract?

6
Pizza Videos

• A pizza store and video store are located next to
  one another.
• The pizza store owner notes that many customers
  order a pizza then go next door to pick up a
  video before returning to pick up their order.
• They wonder if many consumers are looking upon
  pizzas and videos as a joint product.

7
Pricing Game

• The current price of a pizza is 10 and the
  current price of a video is 6. There are
  currently 100 customers who purchase both.
• The pizza store owner reckons that by reducing
  the pizza price by 2, an additional 20 customers
  might be attracted.
• Is this worth doing?

8
Yes and No

• Current profits are 600 for the video store and
  1,000 for the pizza place.
• After the price reduction, the video stores
  profits become 720 while the pizza places
  profits fall to 960. So for the pizza store, the
  discount is not worthwhile?
• But what if they could coordinate their pricing?

9
Coordinating Pricing

• What mechanisms could they use to coordinate
  pricing?
• What impediments do they face to reaching an
  outcome?

10
Strategies for Complements

• Provide the complements individually
• Too few units being produced
• Subsidise the provision of complements by others
• Be subsidised to produce complements
• Form a jointly funded complement provider

11
Identifying Players

• Players differ in their roles in value creation

12
The Value Net

SUPPLIERS
COMPANY
COMPLEMENTORS
COMPETITORS
CUSTOMERS
13
Customers
Your Business
Production Flow
Monetary Flow
Your Customer

• Your customer may be another business, or a
  private consumer
• The production flow and the monetary flow go
  in opposite directions

14
The Value Chain

• Business is engaged in multiple markets buying
  inputs and selling products.

15
Some useful definitions

• Willingness to pay and willingness to sell

16
Decision trees and the Value Net

• Decision trees will provide us with powerful
  tools to analyse Value Net relationships
• In particular, they help define
• Willingness-to-Pay (WTP)
• Willingness-to-Sell (WTS)

17
Willingness-to-Pay

• Willingness-to-Pay (WTP) Price at which a buyer
  is just indifferent to purchasing or not
  purchasing a good
• WTP is the highest price at which a seller can
  hope to sell
• Above this price, the buyer walks away
• Below it, the buyer appropriates an economic
  profit

18
Example

• A Sothebys antiques trader sees a Ming vase for
  sale in China
• 8000 costs to bring the vase to Australia and
  sell it
• There are no taxes
• He is certain that he can sell the vase for
  200,000
• He is not passing up any other alternatives to
  buy this vase
• WTP is the HIGHEST price he is willing to pay
  for the vase
• How do we work this out?

19
Step I Model buyers decision using a decision
tree

• Suppose the price of the vase to the buyer is
  given by p

Buy vase
200,000 8,000 p
Buyer
0
Dont buy
Buy vase
200,000 8,000 100,000 92,000
EXAMPLE p100,000
Buyer
0
Dont buy
20
Step II Calculate how profit depends on the price

• Here it is easy
• Next-best alternative No Purchase
• So, opportunity cost 0.

Economic Profit 200,000 - 8,000 - p
For example, p 100,000 ? buyers economic
profit 92,000 What if p197,000?
21
Step III Calculate the highest price that
implies zero profit
This price is the willingness to pay
In our example, ?B 200,000 - 8,000
p Noting that ?B 0 when p 192,000 we
conclude that 192,000 is the buyers WTP (?B
stands for buyers economic profit)
22
Common confusion

• If you make no profit why would you buy it?
• Why dont you need to get a margin?
• Remember
• we are talking about economic profit NOT
  accounting profit
• Economic profit is relative to your next best
  alternative. Therefore, it is the appropriate
  measure for current decision making. As we have
  seen, past outlays (sunk costs) are irrelevant.
  Moreover, sometimes minimising your loss is the
  best you can (presently) do.

23
Example continued

• Suppose the Sothebys trader has room for 1 more
  item in his shipment
• He has seen another available item and calculates
  that he will earn 15,000 in profit from it
• How does this alter his WTP for the vase?

Now, this branch has value
24
Example continued
Buy vase
200,000 8,000 p 192,000 p
Buyer
15,000
Dont buy
Now, ?B 177,000 p where 177,000 192,000
15,000 So, WTP is reduced from 192,000 to
177,000
25
Why does buyer need to know their WTP?

• To know
• How high to bid in an auction (e.g. for a house)
• Bargaining position for negotiation
• How to avoid mistakes in complex business

26
Utility

• For firms seeking to maximise profits, WTP can be
  expressed in dollar terms it is a business
• For individuals (e.g. consumers) WTP is related
  to the pleasure/use they derive from them
  economists call this utility
• To keep things simple, we will talk about utility
  in dollar terms (be careful 20th cup of coffee
  today same pleasure as 1st?)
• WTP can be objective or subjective but either
  way it is an important concept for a decision
  maker

27
Utility and WTP

• Michael Ryall is thinking about buying a
  Blackberry for 700
• (keep it simple assume a once-and-for-all fee,
  no monthly payments)
• His utility from owning a Blackberry 2000
• buy 2,000 - 700
• Michael
• dont 0
• Cates utility from owning a Blackberry 200
  
• ? she doesnt buy until her office forces one on
  her!

28
Application House Auction

• Typically, you decide on a stopping price
• This is the price at which you stop bidding
• And someone else gets the house
• Suppose your stopping price is 350,000
• Stopping price is your WTP (or just below it)
• You are indifferent between
• Get the house for 350,000
• VS
• Walk away from the deal
• If you get carried away, and bid more than your
  stopping price, youll regret it!

29
Example time and willingness to pay
Dana runs a logging mill. He currently uses a
Mobile Stacker to move logs. But his Stacker
needs replacing. He can either buy another
Stacker for 250,000 or a Portal Crane for 1m
(all prices include delivery and installation).
Both a Stacker and a Crane cost 280,000 per
year to operate. But the Stacker only lasts for 4
years while a Portal Crane lasts for 20 years. He
has decided that he will buy one or the other
(shutting the mill is not an option). Further, he
expects to continue in operations for at least
the next 20 years. But which should he buy?
30
ASIDE Time is money!

• Suppose the interest rate is 5
• Then, 10,000 today ? 10,000 in 1 year!

If you have the money today, you can invest it
10,000 today 10,500 in 12 months. The 5
interest rate is like an exchange rate between
money you have this year, and money you have next
year 1.00 this year 1.05 next year
31
ASIDE discount rates

• Suppose your firm has 2 sources for an input
• The US market (where you have to pay US), or
• The Australian market
• Exchange rate currently US 0.80 US to AU 1.00
• The inputs are available for
• US 450,000 plus AUS 50,000 transportation costs
  or
• AU 650,000 with no transportation costs.
• Where should you get your inputs?
• How do you make the comparison?
• Have to convert everything to the same currency!

32
ASIDE discount rates

• Decision tree require consistent dollars
• Divide US by 0.8 to get equivalent AU, or
• Multiply AU by 0.8 to get equivalent US
• AU 612,500
• Source US
• Firm
• Source AU
• AU 650,000
• It is cheaper to get the goods in the US
• If the exchange rate increases, this may change

33
ASIDE discount rates

• Suppose MBS needs to make repairs to the building
• Cost 100,000 this year
• Cost 104,000 if it waits until next year
• Money earns 5 interest in bank
• Whats left next year, in each scenario?
• Repair today 0
• MBS
• Repair next year 105,000 -
  104,000
• It is cheaper to wait until next year
• At 3, cheaper to go ahead

34
Time is money!

• Given an annual interest rate of r, 1 invested
  today yields 1?(1 r) in one year
• Alternatively, 1/(1 r) invested today yields
  1 in a year
• So, you should be indifferent between
• 1 in one year, and
• 1/(1 r) today (hence, this is the present
  value of 1 one year from now when the interest
  rate is r)
• Note the opportunity cost thinking here!
• Similarly, 1 today and held for 2 years yields
  1?(1 r)? (1 r) (1 r)2
• So 1 in two years has a present value of 1/(1
  r)2
• More generally, 1 in n years time has a present
  value of 1/(1 r)n
• This calculation is called discounting future
  payments
• The discount factor is 1/(1 r) and
  represented by ?
• ? 1 when r 0 ? investors very patient
  consider payoffs far in the future
• ? 0 when r ? (i.e., r huge) ? investors very
  impatient only consider payoffs today

35
Example back to Danas problem

• Current mobile stacker needs replacing
• Either
• Buy another stacker for 250,000 or
• Portal Crane for 1m
• Both cost 280,000/yr to operate
• Stacker lasts 4 years while a
• Portal Crane lasts 20 years.

36
Buy Stacker
Time to replace the stacker!
Dana
Buy Portal Crane

• Note In both cases,
• Running costs are the same, and
• Revenues are the same
• So, we can leave them out.

37
The simplified calculation

• Decision depends upon Danas discount factor
• At ? 1, cost of stacker PV 1,250,000
• At ? 0, cost of stacker PV 250,000

38
When r 5
Mobile stackers are cheaper in PV
39
WTP for a Portal Crane

• Suppose manufacturer of Portal Cranes offers a
  discount. What is Danas WTP for a Portal Crane?
• What would happen to Danas WTP for a Portal
  Crane if
• Interest rates fell from 5 to 3?
• He was unsure whether or not his business would
  last for the next 20 years (and the resale value
  of both a Portal Crane and a Mobile Stacker is
  0)?

40
Willingness-to-Sell

• Willingness-to-Sell (WTS) The lowest price that
  a seller will accept in return for a good or
  service.
• In other words WTS is the price at which
• Seller is indifferent to walking away with no
  sale
• Economic profit from selling is zero

41
Discussion Point Tough bikkies ...

• Caroline bakes excellent chocolate-chip cookies
  in the Midwestern US
• She wants to sell through supermarkets
• She runs into the practice of slotting
• Charged from 3,000 to 25,000 just to place
  products on the retailers shelves
• And, unsold biscuits must be bought back
• Caroline complains on 60 Minutes about
  discrimination against smaller firms

42
response

• Supermarket manager
• I run a good store. Each yard of shelf space in
  my store generates about 10,000 in sales every
  week! If I put a new product on a yards worth of
  shelf space, and if it fails to sell well, I lose
  those 10,000 in sales. That is the real cost to
  me, just as if I had taken money out of the safe
  or written a check. It is a cost even if I get
  the new product for nothing or sell it on
  consignment. It is a cost, because sales are
  foregone or lost

43
Going forward use the tools!

• The decision-making tools discussed last week are
  important for calculating WTP and WTS
• Focus on what makes your payoff different if you
  buy (or sell) versus if you dont
• Dont consider sunk costs
• Dont worry about costs that you pay under either
  decision, or revenues that you earn under either
  decision.
• Consider the time frame (fixed costs, variable
  costs)
• Carefully assess your best alternative to
  transacting
• (? consider all the alternatives)

44
Value Creation
45
1 Buyer, 1 Seller When is trade possible?
pWTP
Buyer will accept a price anywhere on dashed line
Seller will accept a price anywhere on solid line
pWTS

• If WTP ? WTS, transacting creates value
• But if WTP lt WTS, no trade is possible there
  is no price that both will accept!

46
Value created by trade

• What is the value created by trade?
• After the trade, the buyer is better off, and
• Seller is also better off
• (we know theyre better off because they agreed
  to trade)
• Value created by trade
• economic profit of buyer economic profit
  of seller
• (WTP - p) (p
  - WTS)
• WTP - p p - WTS
• WTP - WTS
• Interesting! The value of trade has nothing to do
  with p, the price.
• ? Prices allocate value

47
Economic Profit of the buyer

• In most cases, the economic profit of the buyer
  is equal to (WTP p).
• Sothebys trader sell the vase for 200,000 with
  8,000 of costs
• Or, earn 15,000 on the alternative purchase
• buy 200,000 - 8,000 - p
• Buyer
• dont 15,000
• Traders share of the value (value appropriated)
  is 177,000 p
• WTP p
• his economic profit

48
Economic Profit of the seller

• Economic profit of the seller is (p - WTS)
• Suppose seller can sell vase to a museum for
  120,000
• sell to S p
• Seller
• sell to M 120,000
• Sellers economic profit (value appropriated)
• p 120,000 p WTS

49
Value distribution between buyer seller
Buyers WTP
Price will be somewhere along dashed interval
Total Value Created
Suppliers WTP

• There is no new value unless the buyer and
  seller agree to trade
• ? partners in creating the pie ( cooperation
  stage)
• Price splits that value between them
• ? each wants the most value possible (
  competitive stage)

50
The division of value between buyer and seller
Value captured by...
Willingness -to- Pay
Buyer
Value Created
Price
Seller
Willingness-to-Sell
Bargaining/pricing determines where the price is
on the interval
51
More generally, whats going on when firms reach
agreements with each other?

• Firms do 2 separate things
• Take actions that affect the quantity of value
  created
• Bargain over the division of the value
• Payments firms make to each other affect the
  division of value created, not the amount of
  value created
• In this situation, there is no incentive to
  make inefficient transactions (i.e., those that
  do not create the most value)
• Why leave money on the table?
• Bargaining skill equal, you prefer to create more
  value

52
Multiple agents

• Value created from a multi-agent transaction
• Remember that we define payoffs in a game from
  some arbitrary benchmark, like zero
• ? Its only meaningful to talk about changes in
  payoffs

53
What is the maximum value possible?

• Think of the transactors as a big team or a
  family, doing whats best for the group
• ? Write a decision tree for the group
• ? Look at the sum of payoffs to the whole group
• Example Two banks can either have their own
  network of ATMs for 1m each, or share a network
  that costs 1.2m
• share
• (Bank A Bank B)
• dont

54
Make the pie as big as possible

• Value created by Sharing 0.8m
• (Separately these banks will decide how to split
  the cost of the network. In this simple case,
  theyll probably contribute 0.6m each to the
  cost of the network.)
• Some other sources of value
• Production and trade
• Joint ventures
• Sharing facilities
• Bringing in complements to your product

55
Decision tree for the group, when its cooperating

• If a group is cooperating to maximize value, we
  can think of the group as one unit, with its own
  decision tree
• Then determine which branch gives highest total
  payoff
• Best total payoff to group, if cooperate
• Group
• Total payoff
  to group if dont cooperate,
• each does best
  thing for herself
• (some other
  option)

(some other option)
56
Value from trade on Survivor

• Two tribe members want 1 fish each and 1 coconut
  each
• Both can build a fishing rod and climb the
  coconut tree, or they can trade
• 1 hour to build a fishing rod, 1 hour per fish
• 3 hours for an inexperienced person to climb up
  down a coconut tree and pick coconuts
• trade (payoffs in hours)
• Survivors 1 and 2
• dont
• Is the joint decision tree really this simple?

57
Some things to consider

• Specialization is beneficial when
• There are scale effects (setup costs are one
  example)
• Some people/firms/countries are relatively better
  at some tasks (called comparative advantage)
• Measuring value can be subtle
• Cost to spouse of staying home with the kids if
  his/her professional skills deteriorate without
  use
• Value of on-the-job consumption
• Value of altruism

58
More players

• Complementors and competitors

59
Back to the Value Net

CUSTOMERS
COMPANY
COMPLEMENTORS
COMPETITORS
SUPPLIERS
60
Customer Side Complementors Competitors

• Complementor Your buyers value transacting with
  you more when they also transact with this
  agent(e.g., desktop printer and digital camera
  producers)
• Competitor Your buyers value transacting with you
  less when they also transact with this
  agent(e.g., Coke and Pepsi)

61
Complementor Technical definition

• Two firms are complementors if, to a customer
• WTP (A B) gt WTP (A alone) WTP (B alone)
• Examples
• Hardware and software
• Cars and car loans
• Other sellers on eBay
• Intel and Windows
• there is more value if a complement is present

62
Complementor Example

• WTP (A B) gt WTP (A alone) WTP (B alone)
• Suppose that, for the average customer
• Before digital camera, WTP for a desktop colour
  printer is 400
• BUT, w/digital camera, WTP for a colour printer
  is 500
• If colour printers dont exist (or they are so
  expensive that she wont buy one), WTP for a
  digital camera is 80
• BUT, w/colour printer, WTP for a digital camera
  is 150
• If colour desktop printers cost 450 to make
  initially, and digital cameras cost 100 to make,
  this market may never get started!

63
Complementors and value

• Creating value sometimes no complementors, no
  pie
• (i.e. if total WTP lt WTS, zero value created
  since no trade)
• Need to get complementors in the market
• Chicken-and-egg story
• Who will invest first?
• Who will enter the market first?
• a key problem in most high-technology markets

64
Bringing in complementors

• Example Common funds
• 1913 GM, Hudson, Packard created the Lincoln
  Highway Association to fund seeding miles
• 1999 Compaq, Sun, Netscape and Oracle provided a
  100m Java development fund

65
Complementors and appropriation

• Everyone would like cheap complements
• Example Vacation spots
• Hotels need airlines, airlines need hotels
• Allied or conflicting interests?
• Consumer cares about pa ph
• Each firm wants the other to be cheap
  (appropriate less)
• Division before creation firms trying to gain
  too large a share of the pie can destroy it.

66
Other solutions

• Chicken-and-egg problems can also be solved via
• Contractual price agreements
• Price bundles of goods
• Vacation packages,
• Software applications,
• Cinema and food at Jam Factory
• Become your own complementor
• Create the complement, and
• Solve the pricing problem
• Example What business is USAA in?
• Roadside assistance
• Insurance
• Travel planning
• Auto buying club
• Financial products

67
Competitor Technical definition

• Two firms are competitors if, to a customer
• WTP (A B) lt WTP (A alone) WTP (B alone)
• Examples
• Coke and Pepsi
• Qantas and Virgin Blue
• IBM PCs and Macs

68
Your Competitor Foe or Friend?

• The presence of a competitor
• reduces the profits you make from an existing
  base of customers
• BUT
• From customers perspective
• More variety increases the chance of satisfying
  needs
• More likely to pay a lower price
• Customer more likely to enter the market if there
  is competition
• Higher volume may offset lower appropriation per
  transaction
• Antique stores on High Street, Armadale
• Theater, music, dance on and off Broadway
• Shopping malls

69
Supplier SideTechnical definition of a
complementor

• Firm B is your complementor on the supply side
  if, for suppliers,
• WTS(AB) lt WTS(A) WTS(B)
• Economies of scale and scope
• Fixed operating costs (not sunk!) for railroad
  distributors
• Organizational know-how for engine design
• Peak and off peak
• cricket and football
• network usage

70
Your Competitor Foe or Friend on the supply
side?

• The presence of another firm competing for the
  same inputs
• Raises price you pay to suppliers
• BUT
• Increases the chance a supplier will benefit from
  economies of scale/scope
• Guarantees the supplier a higher price
• Suppliers more likely enter the market/invest RD
  if there is competition
• Your competitor may help enlarge the pie!
• HP and Dell Compete for Intel chips, worthwhile
  for Intel to invest in RD

71
Multiple Roles Jekyll and Hyde

• Competitive threat or complementary opportunity?
• Movie theatres video rentals
• Traditional Internet booksellers
• Computers and paper paperless office
• ATM machines - the fate of Citibank

72
Friend or Foe?

• Traditional view
• Friends
• Customers, Suppliers, Complementors
• Foes
• Competitors
• Co-opetition most players are both friends and
  foes
• Partners in creating value
• Competitors in dividing the value

73
Identifying Players

• Case Credit Card Industry