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"Fun and Games Theory" by David R. Henderson, Fortune, July 15, 1991.

Ahead three races to one in his best-of-seven defense of the America's Cup in 1983, skipper Dennis Conner goofed big time. After taking the lead in the fifth race, he could have neutralized the uncertainty of shifting winds simply by imitating whatever his Australian rival did. Instead, when his opponent swung way left in search of a better breeze, Conner stayed right. The Aussies got lucky, beat him, and went on to win the next two races and the cup as well. What does this mistake have to do with, say, IBM's competitive strategy? A lot, as Avinash Dixit and Barry Nalebuff point out in their excellent book, Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life (W.W. Norton, $24.95). If IBM goes down a different path by innovating and its new machine doesn't work, the computer industry leader has a lot to lose. IBM's solution: Let upstart companies innovate, and if their new products are successful, copy them quickly. In other words, follow the innovator. (For Big Blue's struggle to cope with such competitive problems, see Cover Story.)

The science of strategy that Dixit, an economist at Princeton, and Nalebuff, an economist at Yale, have written about is called game theory. In game theory you consider what person A should do, given the various actions person B might take, either independently or in response to A's actions. Sometimes this way of thinking can lead you nowhere, a risk the authors illustrate with a joke about two rival businessmen who meet in the Warsaw train station.

"Where are you going?" says one.

"To Minsk," replies the other.

"To Minsk, eh? What a nerve you have! I know that you are telling me that you are going to Minsk because you want me to believe that you are going to Pinsk. But it so happens that I know you really are going to Minsk. So why are you lying to me?"

When I read this, it reminded me of the hilarious scene in one of my daughter's favorite movies, The Princess Bride, in which a villain and self-proclaimed mental giant employs similarly convoluted reasoning to try to figure out which of two cups of wine contains poison. He ends up killing himself.

To help you avoid such an unhappy fate, Dixit and Nalebuff set out a few sure-fire rules for thinking about strategy. Rule No. 1: Look ahead and reason back. Anticipate the results of your initial decisions and use this information to settle upon your best choice. But in some situations, they note, you can develop what is called a dominant strategy—one that you should take no matter what choice your rival may make. So Rule No. 2 is, If you have a dominant strategy, use it.

Dixit and Nalebuff note that OPEC members Iran and Iraq, for instance, would both like to keep the oil cartel's production low in order to push prices up. But if Iran sticks to the cartel agreement, then Iraq's best strategy is to cheat by producing more than its assigned quota—thus making more money. If Iran cheats, then Iraq's best strategy is still to cheat. High production, in short, is both countries' dominant strategy. Now you understand why cartel agreements rarely last.

For lay readers, the abundance of such lively and interesting examples of how game theory illuminates ordinary life is what will make Dixit and Nalebuff's book so appealing. But be forewarned: Other parts of their exploration of this arcane science, though rewarding, are hard slogging. My suggestion is to approach the more technical parts the way you work on puzzles—like the one about Tom, Dick, and Mary who are lawyer, doctor, and singer, but not in that order. If you do, you'll find your efforts amply repaid.

 

Copyright © 2008 by Avinash Dixit and Barry Nalebuff