Competition and Cooperation Revised: October 22, 2001 The language of business is frequently based on the language of competition, or even war. In fact, business has elements that are competitive, and other elements that are cooperative; elements that are zero-sum, and others that are positive-sum; elements focused on creating value, others focused on distributing value. Without the cooperative elements, the competitive ones wouldn’t be worth the effort. This session is devoted to restoring the balance. We’ll look at situations in which firms are as much allies as adversaries and explore ways in which they might develop their common interests. Examples include: •= Microsoft and Windows. Since both depend on the health of the PC market, they have a clear common interest. Which is not to say that their interests are the same. •= Management and labor. Other things constant, a firm makes more money if its labor costs are lower. But disagreement between management and labor shrinks the pie and potentially leaves both worse off. Surely one of the reasons Southwest is more efficient than US Airways or United is that they do not have a history of labor-management strife. •= International trade. The logic of trade, which has been understood by specialists (if no one else) for almost two centuries, is that both countries benefit. Voluntary trade creates value that benefits both sides. •= Stern students. There’s a narrow sense in which one student’s success comes at the expense of another’s: not everyone can get the highest grade. But there’s a more important sense in which students have a common interest: you learn from each other, share insights and contacts, and the success of your fellow students increases the reputation value of a Stern degree. Such combinations of cooperation and competition were dubbed “co-opetition” by Novell’s founder, Ray Noorda. The message is not that you should be nice in business (although courtesy remains a virtue, even in the 21st-century business world), but that you should understand (i) when you and others have similar interests and (ii) how to take advantage of them. Common Interests Firms and MarketsLecture NotesCollusion Page 2 Some decisions concern the creation of value, others how to divide it up: making the pie and fighting over its pieces. Let’s start by stressing the “creating value” part of business relationships. Consider the relation between a firm and its suppliers. On the one hand (the economist in us speaking!), a firm does better if it gets a low price on its inputs. On the other, the firm and supplier both benefit if the final product does well. Take two airlines, American and Delta. In one sense, they are in direct (and often quite cutthroat) competition for market share, landing slots, and gates. Yet these firms also complement each other. How? They both buy planes from Boeing. These planes are expensive for Boeing to design and produce. If only Delta purchased planes from Boeing, it might not be enough to allow Boeing to invest in improved design features. Moreover, aircraft manufacture benefits from a step learning curve: the more Boeing produces, the cheaper they can sell them. So if American buys more, there’s a clear indirect benefit to Delta. There’s a similar logic for a firm and its employees. Suppose you are the representative of a labor union, and I am an executive of a corporation. We are engaged in negotiations over the next contract. We realize we don’t have identical interests. I think that you want an unreasonable wage hike and excessive vacation time; you think I am an indifferent manager who wants to deny you any added benefits or share in the firm’s success. I think any gain you receive will be at my expense. You think that any denial of your demands results in a win for me. This is a distributive, zero-sum mindset where we each think there is no way to win without the other side losing. But picture a somewhat different scenario. Suppose I (the executive) believe that profits will be way up in the next five years thanks to efficiency gains in the firm’s productive capital, and thus its labor. As a result, I am willing to give quite a bit on wages to reflect these productivity gains. Nevertheless, I am adamant in opposing any additional vacation benefits, which raise cost without increasing productivity. Similarly, suppose you (the labor rep) are flexible over vacation time, but adamant about wage increases. Suddenly, there’s a clear win-win possibility. You and the manager can cooperate on those issues on which you agree. A more subtle example brings us back to the Bertrand trap of price-cutting: if we are direct competitors, can we avoid the destructive temptation to undercut each other’s prices? Clearly we would both gain if we understood that cooperation on price benefits each of us. In this case, there’s a legal issue, too, since getting together to fix the price violates antitrust law in the US and many other countries. But if we simply understand our common interest, perhaps we could approach the same outcome without explicit agreement. Cooperation as a Nash Equilibrium Let’s continue with the price-cutting game we studied earlier. How might firms learn to avoid behavior that is mutually destructive?Collusion Page 3 One answer – the one we’ll spend our time on – is that when firms interact repeatedly over time, they might be able to avoid the short-run temptation to cut prices or otherwise act in their narrow self-interest. If two firms compete not only today, but tomorrow and the next day and so on, this gives each of them leverage over the other. If one cuts prices too low today, the other can instigate a price war to punish it tomorrow. Take OPEC as an example to see how this might work. Oil-exporting countries meet periodically to restrict output, setting output quotas for each country. Say in country X the quota is 100,000 barrels per day. What if the country actually produced 120,000 to generate additional revenue? After all, no judicial body enforces the cartel agreement. If others stick to the agreement, this will keep the price high and increase the benefits of producing more. In the language of game theory, country X has an incentive to “cheat” on its agreement with OPEC to limit supply. If others cheat (after all, they have the same