PoS June 2015 | How Nash Equilibrium Guides Competitive Strategy
John Nash became a household name thanks to the Hollywood movie A Beautiful Mind. He died tragically in a car crash on 23rd May. Fortunately his contribution to Game Theory, for which he was awarded Nobel Prize in 1994, lives on.
I have often been asked how Nash Equilibrium can be used to shape a firm’s competitive strategy.
Game Theory is a study of choices players can make when outcome of their interaction depends on strategies of other players. If you have a strategy that is better than any other that is available you should play it, your dominant strategy. When each of two players plays their dominant strategy, dominant strategy equilibrium is achieved.
John Nash established that if a multi-player game is played a finite number of times, and each player played his or her dominant strategy, the game would culminate in Nash Equilibrium. No one would then do better by unilaterally changing his or her strategy.
Nash Equilibrium has helped India design coal block and spectrum auctions. It is why auctions fetch better prices for artworks and buyers resort to closed tenders to obtain low prices from vendors.
The Fittest Survive
Nash predicted that in a price war Nash Equilibrium would be reached when all parties have reached the lowest price at which they are willing to sell, usually the marginal cost of production. Since marginal cost varies from company to company, the player with the highest cost would exit first and the one with the lowest would win.
In product categories that have high price elasticity, commodities usually, pursuing low cost strategy makes sense. Michael Porter’s generic strategy of Cost Advantage urges a firm to achieve the lowest cost of serving customers in its industry.
Managers Don’t Like It
Cost Advantage is not a popular choice among managers. They are wrong to ignore it. Some of the most successful companies have adopted it. Asian Paints has been the leader and the most profitable company in the Indian paint Industry for several decades on the back of this strategy. Maruti Suzuki, the largest Indian car maker, Toyota, Southwest Airline, Reliance Industries in petroleum refining, and many others are celebrated examples of this strategy.
What About Differentiation?
Fortunately Nash Equilibrium can lead to attractive prices too. In industries with low or moderate price elasticity of demand, prices can rise to Nash Equilibrium. Low elasticity is a characteristic of uniqueness, or strong customer loyalty arising from superior and distinctive value delivery. This is the foundation of Porter’s generic strategy of Differentiation. Firms can achieve uniqueness through design, features, service, or a combination of relevant value drivers.
Unilever, Starbucks, and Johnson & Johnson all pursue differentiation on the bases of product uniqueness and branding. Ikea leverages design and purchasing experience to create its distinctive appeal. Sigma Aldrich the specialist chemicals company differentiates itself on outstanding technical service in a commodity industry.
Nash Equilibrium and Strategy
Cost leadership and compelling distinctiveness create entry barriers and reduce rivalry in an industry. They discourage mavericks from starting price, promotion, or advertising wars. Both strategies can lead to Nash Equilibrium. Which one a firm uses to chart its destiny depends on the ingenuity of its managers.
Related reading: Game Theory: Prisoners’ Dilemma on Thanksgiving Day