ME Cooperative DM JG 2006

Cooperative Decision-Making: 

Cooperative Decision-Making How to identify opportunities for value creation and exploit them

Key Economic Skill: 

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

Neighbourhood Blues: 

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

Answer: Depends on Value: 

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?

The Coase Theorem: 

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?

Pizza Videos: 

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.

Pricing Game: 

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?

Yes and No: 

Yes and No Current profits are $600 for the video store and $1,000 for the pizza place. After the price reduction, the video store’s profits become $720 while the pizza place’s profits fall to $960. So for the pizza store, the discount is not worthwhile? But what if they could coordinate their pricing?

Coordinating Pricing: 

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

Strategies for Complements: 

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

Identifying Players: 

Identifying Players Players differ in their roles in value creation

The Value Net: 

The Value Net COMPETITORS SUPPLIERS COMPANY COMPLEMENTORS CUSTOMERS

Customers: 

Customers Your Customer Your Business Production Flow Monetary Flow Your customer may be another business, or a private consumer The 'production flow' and the 'monetary flow' go in opposite directions

The Value Chain: 

The Value Chain Business is engaged in multiple markets: buying inputs and selling products.

Some useful definitions: 

Some useful definitions Willingness to pay and willingness to sell

Decision trees and the Value Net: 

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)

Willingness-to-Pay: 

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

Example : 

Example A Sotheby’s 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?

Step I: Model buyer’s decision using a decision tree: 

Step I: Model buyer’s decision using a decision tree Suppose the price of the vase to the buyer is given by p Buyer Buy vase Don’t buy 200,000 – 8,000 – p 0 EXAMPLE: p=100,000 Buyer Buy vase Don’t buy 200,000 – 8,000 – 100,000 = 92,000 0

Step II: Calculate how profit depends on the price: 

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  buyer’s economic profit = $92,000 What if p=$197,000?

Step III: Calculate the highest price that implies zero profit: 

Step III: Calculate the highest price that implies zero profit In our example, B = $200,000 - $8,000 – p Noting that B = 0 when p = $192,000 … … we conclude that $192,000 is the buyer’s WTP (B stands for buyer’s economic profit) This price is the willingness to pay

Common confusion: 

Common confusion If you make no profit why would you buy it? Why don’t 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.

Example continued: 

Example continued Suppose the Sotheby’s 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

Example continued: 

Example continued Now, B = $177,000 – p where 177,000 = 192,000 – 15,000 So, WTP is reduced from $192,000 to $177,000 Buyer Buy vase Don’t buy 200,000 – 8,000 – p = 192,000 – p 15,000

Why does buyer need to know their WTP?: 

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

Utility: 

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

Utility and WTP: 

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 don’t $0 Cate’s utility from owning a Blackberry = – $200  she doesn’t buy until her office forces one on her!

Application: House Auction: 

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, you’ll regret it!

Example – time and willingness to pay: 

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?

ASIDE: Time is money!: 

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

ASIDE: discount rates: 

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!

ASIDE: discount rates: 

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

ASIDE: discount rates: 

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 What’s 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

Time is money!: 

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

Example – back to Dana’s problem: 

Example – back to Dana’s 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.

Slide36: 

Dana Buy Stacker Buy Portal Crane Note: In both cases, Running costs are the same, and Revenues are the same So, we can leave them out. Time to replace the stacker!

Slide37: 

Decision depends upon Dana’s discount factor At  = 1, cost of stacker = $PV 1,250,000 At  = 0, cost of stacker = $PV 250,000 The simplified calculation

Slide38: 

Mobile stackers are cheaper in $PV When r = 5%

WTP for a Portal Crane: 

WTP for a Portal Crane Suppose manufacturer of Portal Cranes offers a discount. What is Dana’s WTP for a Portal Crane? What would happen to Dana’s 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)?

Willingness-to-Sell: 

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

Discussion Point: Tough bikkies ...: 

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 retailer’s shelves And, unsold biscuits must be bought back Caroline complains on ‘60 Minutes’ about discrimination against smaller firms

… response: 

… 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 yard’s 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 …'

Going forward: use the tools!: 

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 don’t Don’t consider sunk costs Don’t 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)

Value Creation: 

Value Creation

1 Buyer, 1 Seller: When is trade possible?: 

1 Buyer, 1 Seller: When is trade possible? pWTP Buyer will accept a price anywhere on dashed line pWTS If WTP  WTS, transacting creates value But if WTP andlt; WTS, no trade is possible: there is no price that both will accept! Seller will accept a price anywhere on solid line

Value created by trade: 

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 they’re 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

Economic Profit of the buyer:: 

Economic Profit of the buyer: In most cases, the economic profit of the buyer is equal to (WTP – p). Sotheby’s 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 don’t $15,000 Trader’s share of the value (value appropriated) is = $177,000 – p = WTP – p … his economic profit

Economic Profit of the seller: 

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 Seller’s economic profit (value appropriated) = p – $120,000 = p – WTS

Value distribution between buyer & seller: 

Value distribution between buyer andamp; seller Buyer’s WTP Price will be somewhere along dashed interval Supplier’s WTP Total Value Created 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)

The division of value between buyer and seller: 

The division of value between buyer and seller Willingness -to- Pay Price Willingness-to-Sell Value Created Buyer Seller Value captured by... Bargaining/pricing determines where the price is on the interval

More generally, what’s going on when firms reach agreements with each other?: 

More generally, what’s 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

Multiple agents: 

Multiple agents Value created from a multi-agent transaction = ** Remember that we define payoffs in a game from some arbitrary benchmark, like zero **  It’s only meaningful to talk about changes in payoffs

What is the maximum value possible?: 

What is the maximum value possible? Think of the transactors as a big team or a family, 'doing what’s 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 andamp; Bank B) don’t

Make the “pie” as big as possible: 

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, they’ll 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

Decision tree for the group, when it’s 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 don’t cooperate, each does best thing for herself (some other option) Decision tree for the group, when it’s cooperating (some other option)

Value from trade on “Survivor”:: 

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 andamp; down a coconut tree and pick coconuts trade (payoffs in hours) Survivors 1 and 2 don’t Is the joint decision tree really this simple?

Some things to consider: 

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

More players: 

More players Complementors and competitors

Back to the Value Net:: 

Back to the Value Net: COMPETITORS CUSTOMERS COMPANY COMPLEMENTORS SUPPLIERS

Customer Side: Complementors & Competitors: 

Customer Side: Complementors andamp; 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)

Complementor: Technical definition: 

Complementor: Technical definition Two firms are complementors if, to a customer: WTP (A + B) andgt; 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

Complementor: Example: 

Complementor: Example WTP (A + B) andgt; 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 don’t exist (or they are so expensive that she won’t 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!

Complementors and value: 

Complementors and value Creating value: sometimes no complementors, no pie (i.e. if total WTP andlt; 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

Bringing in complementors: 

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

Complementors and appropriation: 

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.

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 Other solutions

Competitor: Technical definition: 

Competitor: Technical definition Two firms are competitors if, to a customer: WTP (A + B) andlt; WTP (A alone) + WTP (B alone) Examples: Coke and Pepsi Qantas and Virgin Blue IBM PCs and Macs

Your Competitor: Foe or Friend?: 

Your Competitor: Foe or Friend? The presence of a competitor… … reduces the profits you make from an existing base of customers BUT From customer’s 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, andamp; dance on and off Broadway Shopping malls

Supplier Side:Technical definition of a complementor: 

Supplier Side: Technical definition of a complementor Firm B is your complementor on the supply side if, for suppliers, WTS(A+B) andlt; 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

Your Competitor: Foe or Friend on the supply side?: 

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 Randamp;D if there is competition Your competitor may help enlarge the pie! HP and Dell: Compete for Intel chips, worthwhile for Intel to invest in Randamp;D

Multiple Roles: Jekyll and Hyde: 

Multiple Roles: Jekyll and Hyde Competitive threat or complementary opportunity? Movie theatres andamp; video rentals Traditional andamp; Internet booksellers Computers and paper: 'paperless' office ATM machines - the fate of Citibank

Friend or Foe?: 

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

Identifying Players: 

Identifying Players Case: Credit Card Industry