Shaping winning business strategies with game theory: strategic gaming, based on modeling techniques created by John Nash, can help companies focus on what rivals are thinking and enhance their competitive positions. (Strategy).

Challenged as never before with designing a high-value company game plan, executives often get blindsided by competitors' moves they failed to anticipate. To safeguard against nasty surprises, you must think carefully about what actions competitors might take.

Strategic Gaming -- a structured, comprehensive approach to putting yourself in your competitors' shoes -- enables you not only to play the competitive game more effectively, but also to create one that improves your value prospects by influencing other players' actions.

Based on the developments of game theory pioneered by John Nash, the subject of the movie "A Beautiful Mind," Strategic Gaming can help answer crucial strategic questions. Should we compete? Should we partner with a potential competitor? Cooperate? How? On the compete side, it addresses questions like:

* Should we innovate, and at what cost?

* Should we set prices to maximize profit or to deter potential market entrants?

* What strategy should we adopt for competitive-bidding situations?

These questions often arise in sectors where companies face difficult investment, pricing and bidding decisions that depend on the choices their competitors will make. Other applications include capacity bidding for infrastructure projects where the game lies in creating the downstream options the infrastructure provides.

On the partnering side, companies ask who they should partner with, at what price and on what terms. In partnership negotiations and in other types of negotiations, Strategic Gaming helps you avoid leaving value on the table by helping you understand your bargaining power, define your negotiating position and gain insight into effective negotiating tactics.

In seeking answers to any of these strategic questions, Strategic Gaming enables players to see the entire chessboard and to gain and exploit advantages. To play successfully, you must apply three principles:

* Identify the key players and their choices, then creatively explore their full range of choices. By properly framing the situation, you avoid wasting resources by focusing on too many players or the wrong ones. Considering other players' choices also may help you better understand their opportunities, and yours. You may also realize that players you thought were important actually lack influence.

* Lay out the sequence of moves in the game, and take uncertainty into account. Nothing better aligns your team on the challenges than explicitly identifying what each player can do, and when. Clearly identifying and assessing private information, known only to some players, and chance events prevents your team from running blindly down a path that vitally depends on a highly unlikely outcome.

* Value the payoffs to each player. In considering competitor choices and moves, there is no substitute for explicit valuation of the payoffs to each player. Too often, executives skip this step because they deem it too hard to reliably determine how a competitor values a certain outcome. But time and time again, calculations with simple assumptions can radically change one's perspective.

To understand how Strategic Gaming works, consider the compete-versus-cooperate dilemma faced by a company we will call "Nash." Nash was about to launch a new technology, x-factor, which required a $200 million investment but could be a blockbuster in a $1 billion market. But great uncertainty remained about market size and margins because of two potential competitors, Genius Tech and Smart Inc. Some of the Nash team began to question the launch strategy -- perhaps a partnership with Genius or Smart might be preferable to going it alone.

The dilemma was complicated by unconfirmed reports that Genius Tech might have a similar technology it could launch at roughly the same time as Nash's x-factor. Meanwhile, Smart was working on x-factor-plus, which would likely be superior to Nash's product, given Smart's technological prowess. However, x-factor-plus was still several years from launch. Partnering with Smart or Genius could reduce Nash's competitive pressures and risks, while enhancing market power. But it could also mean that Nash would leave value on the table by unnecessarily sharing upside rewards, and partner "drag" could hurt x-factor's potential.

Strategic Gaming provided the insights Nash needed to solve the dilemma, and it helped Nash executives create a "dynamic roadmap." First, the Nash team mapped out Genius and Smart's choices, in sequence, with a "game tree" diagram to represent the structure of the situation. In this process, Nash realized that Smart and Genius might indeed create a partnership combining Genius's commercial power and Smart's technical prowess -- a scary proposition that Nash hadn't seriously considered before.

But did a partnership make economic sense for Genius and Smart? Analyzing uncertainties and payoffs enabled the Nash executives to gain deeper insights. The team explicitly evaluated the situation from the perspective of both Genius and Smart, and arrived at a disturbing answer: They were natural partners, and joining forces to compete against Nash appeared to be their best choice, unless Nash could forge an alliance with one of them. This also revealed that Nash's go-it-alone strategy was worth at least $100 million less than the $300 million they had previously projected. Partnering now became crucial for Nash.

Most Nash executives saw Genius as their preferred partner, assuming Genius successfully developed x-factor. After all, Smart's x-factor-plus wouldn't hit the shelves for another two years, and there was no guarantee that it could achieve technical success. But a small core of vocal Nash executives disagreed. They argued that Genius might not have x-factor at all, and if so, "We'd give away the farm if we make a deal with them!"

Analyzing the payoffs more closely, Nash estimated how much it should take to persuade Genius or Smart to join with Nash, and when Nash should simply give up and go it alone. The analysis also considered the probability of Genius having x-factor and Nash's expected payoff from a deal with Genius or Smart, or from going it alone.

A key insight emerged: Nash's best choice was to seek a partnership with Smart first, unless Nash believed there was at least an 80 percent probability that Genius had x-factor. But Nash didn't believe it. The combination of Smart's technology and Nash's market potential promised a huge potential upside for both Nash and Smart. Unconvinced that Genius had x-factor, Nash decided to go with Smart.

Nash then was able to construct a dynamic roadmap to shape and play the game as it unfolded:

* First, approach Smart with the deal developed in the earlier evaluation. Suggest to Smart that Nash would be willing to go with Genius, absent a deal with Smart. This could be an effective tactic because the analysis showed that Smart should greatly fear a Nash-Genius marketing alliance.

* Second, if the deal with Smart broke down, approach Genius, proposing the deal suggested by the evaluation -- but with the key condition that Genius prove it has x-factor. Thus, Nash could secure a deal with Genius under the only conditions in which such a deal would be desirable.

* Third, if Genius refuses a deal, threaten a bidding war to get an alliance with Smart, a war that the analysis has shown that Nash would win. The concessions required of Nash to win such a battle would still be smaller than the expected value of the deal.

* With its strategic roadmap in hand, Nash was ready to play the game in a way likely to secure the best possible outcome. In the end, Nash had virtually ensured that it could get the right deal at the right price.

How can you adapt this Strategic Gaming approach to your company's challenges? First, frame the problem: map out the key players and their choices, in sequence, to view the structure of the situation. Next, evaluate the choices: bring payoffs and uncertainties into the analysis so you can gain deeper insights into the likely actions of each player. Finally, develop an execution plan: construct a dynamic roadmap to shape and play the game as it unfolds. Committing to this structured approach will ensure that you deeply understand your competitive position and play the game to maximum advantage.

Paul Papayoanou ([e-mail]) is a Senior Consultant and Jay Goldman ([e-mail]) is a Senior Engagement Manager in the Boston office of Strategic Decisions Group. Papayounou leads SDG's applications of Strategic Gaming.