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Faculty Viewpoints

The Practical Game Theorist

Barry Nalebuff, the Milton Steinbach Professor of Management, extracts real-world insights from game theory and microeconomics to improve innovation, strategy, and negotiation. He has applied his approach to multiple entrepreneurial ventures, including Honest Tea.

Q: Is there a core question that has guided you through your career?

I would say it’s more the case that I’ve had an opportunity to reinvent myself every decade. I use the tools of microeconomics and game theory, so that’s consistent, but the nature of the problems considered has changed.

I started off working on problems of voting and aggregating people’s preferences. I worked on problems showing the existence of an equilibrium in cases where demand functions were quasi-concave rather than just concave. If that sounds technical, that’s because it is, in fact, technical. At that time, I was based in economics departments, first at Harvard and then at Princeton. Those are the types of questions that are often addressed in economics departments.

After 10 years of working on my dissertation and being at Harvard and Princeton, I moved to Yale and the School of Management. One of the reasons I came to SOM is I wanted the work I was doing to be more connected to practice—not so much responding to the academic literature but to the world. When you’re at a management school, you have great opportunities to meet with practitioners. Your students are interested in theories to the extent they are practical.

Early on, I did work with Adam Brandenburger on the topic of co-opetition—companies competing and cooperating at the same time. That tied into work on the role of complements and the business strategy of bundling—selling items in packages rather than selling them as components, Microsoft Office as a good example of that. There was also work on antitrust and the aspects of predatory pricing and unfair competition.

Later, I focused on innovation. That led to a book with Ian Ayres called Why Not? We thought about ways of systematizing problem solving.

My focus for the last decade has been on questions of negotiation. That’s partly because I’ve been teaching it, but also because I’ve been writing about it. I have a new book that I hope is nearly done.

Q: You’ve had your own experiences as a practitioner. How did you move from academic work to an entrepreneurial venture?

“The question was, was the theory wrong or was the market wrong? I was willing to bet on the market being wrong.”

I had been teaching a case study of Coke versus Pepsi. I wondered why all the beverages out there were so sweet. One of the things that economics teaches us is declining margin utility. The first bit of something is great. The second bit is pretty good. Each additional unit has less and less value. If we believe in declining marginal utility, then that should be true for sugar and sweetness. But the beverages that were out there were incredibly sweet, or diet, or entirely unsweetened. What the market was doing seemed to violate economic theory. The question was, was the theory wrong or was the market wrong? I was willing to bet on the market being wrong.

I had talked about this often with my students. Fortunately, one of them agreed with me and thought that we should do something about it. That was Seth Goldman. Three years after he graduated, after he’d been at Calvert Fund and had a little bit of a nest egg and was itching to do something more entrepreneurial. We started Honest Tea.

Q: That was 1998. Since then, more than 2.5 billion bottles of Honest Tea have been sold. Coke now owns it. What about Honest Tea is most meaningful to you?

For me, it was the idea that you could have a successful business without sacrificing your ideals. H. L. Mencken claimed that, “No one in this world so far as I know has ever lost money by underestimating the intelligence of the great masses of the plain people.” We showed that it’s also possible to create a successful product that appeals to the intelligence of the customer.

I like to think of Honest Tea as a business that is in line with the SOM ideals of leadership for business and society.

Q: Are there other instances you would highlight as bringing in those values?

If you think about co-opetition, most strategy classes focus on beating the competition, burying them, making a killing—business as war. A lot of people take the Donald Trump view that it’s a zero-sum game.

While we’re not denying the competitive nature of business, that leaves out the potential for making bigger pies. Cooperating with your rivals is incredibly important and not very well understood. Similarly, people focus on competitive products and substitutes, but they don’t understand the idea that complements actually make what you do more valuable, not less.

“A theme that goes through much of my work is a focus on two core activities: capturing value and creating value. Capturing value is fundamentally competitive. Creating value is fundamentally cooperative.”

We helped introduce the theory of co-opetition 25 years ago. We’re in a moment now where it may be particularly relevant. Cars are moving to autonomous driving and from gasoline powered to electric powered; those transitions create disruptions, which often lead to interesting and unusual partnerships.

As I’m talking, I realize there is a theme that goes through much of my work, a focus on two core activities. One is capturing value, and the other is creating value. Capturing value is fundamentally competitive. Creating value is fundamentally cooperative.

When I teach strategy, I talk about that duality in terms of your interactions with other firms, with customers, with suppliers, and complementors. When I teach negotiation, they are there again in the idea of creating a larger pie and capturing your fair slice.

Q: Where did that approach to negotiation come from?

The way we teach negotiation at Yale SOM is really different because we have a theory-based approach. I’m applying work by John Nash and Lloyd Shapley in game theory to practical negotiation problems. You don’t need an advanced degree in mathematics to follow the logical arguments or apply the insights.

For years, game theory has been getting to be more and more of a branch of mathematics. My work is going the other direction. I like to think of myself as having a foot in both the academic world and the practical world. I take some of the axiomatic approaches that you find in the literature and make them relevant to people who have to negotiate. It’s applying insights from theory to change practice.

Something that I think is true about SOM is that, in the way the Yale Law School is the most intellectually based law school, we’re the most academically based management school.

Q: Can you summarize your model for negotiation?

A lot of people are uncomfortable with negotiation. I think one of the reasons why is that they don’t start off with the question of, what is the purpose of the negotiation? In my view, the pie you are trying to divide is how much better off the two parties can be if they reach a deal compared to no deal.

In that framework, if either side walks away, both sides lose the ability to share that value. So right from the start, you see a symmetry. It’s not that A, even if it is a much larger company, is more important than B for creating this value. A and B are equally necessary. If you measure the pie correctly, you understand that the two sides need each other just as much and should share the pie equally. That gets rid of the contentious part and allows people to focus on making the pie bigger, which is the cooperative part.

If you agree upfront that your goal is to create a large pie and to split it evenly, then there’s much less worry and concern. It’s often a great idea to start negotiation with ground rules. If you just jump in, people may keep information hidden. They may not feel like they’re in a cooperative framework because they’re worried everything they say can and will be used against them.

Also, if you propose the cooperative framework, the other side may reject it and say, “I don’t care about that. I just want to take you to the cleaners.” If that’s the case, then you’ve been warned at the outset and maybe should find somebody else to negotiate with.

Q: How did your work on innovation with Ian Ayres of Yale Law School come about?

I was at his birthday party and people were roasting him about some of his crazier ideas. As they were making fun of things he had proposed, again and again I thought, one, I’ve had that idea and, two, I think it’s a great idea. I realized I had found a fellow traveler.

We looked at how we came up with our ideas and whether that same process of creativity that works in academia could be useful to problem solving in the world. We broke it down into a few approaches to developing creative solutions: here’s what you do when incentives are misaligned; or what would you do if you had unlimited resources and then worked on making the solution cheaper; or turn things around, or take an idea from one context and apply it elsewhere. It’s a way to routinize and mechanize the process of problem solving.

Q: Are there examples of ideas in Why Not? that have been put into practice since it was published in 2003?

An easy one is being able to set your phone to stop taking calls from 10:00 p.m. to 8:00 a.m. or whatever times you want it shut off.

A more important one has been implemented in Europe and Australia. We asked, if you’re paying 4% for your mortgage and getting 0% on your checking account, why isn’t it possible to prepay your mortgage, which is like getting a 4% return on the money, and be allowed to de-pre-pay—that is, take money back out of the pre-paid amount when you need cash to repair your house or car or whatever.

An Australian bank came up with a simpler version of the idea, which is to offer a checking account which pays interest at the same rate as your mortgage. It was taken up by Royal Bank of Scotland and is now the most popular way of doing a mortgage in the UK.

Q: How about ideas you proposed that haven’t been implemented?

Here’s something that still frustrates me. Even if we can’t pass a tax on carbon, we don’t have to subsidize people who drive more—which is exactly what we do because of the way insurance is sold. If you pay $1,200 a year for auto insurance, the price is the same whether you drive 10,000 miles or 100,000 miles. (Some companies will give you a low-mileage discount if you drive fewer than 7,500 miles annually, but for the most part people who drive less are subsidizing those who drive more.) Women, who drive half as much as men and pay the same amount for auto insurance, are subsidizing the men.

When we lease cars, we accept a mileage limit. The 20¢ charge for additional miles is a disincentive to driving more. We charge people 10 times as much for gasoline if they drive 100,000 miles instead of 10,000. The obvious solution is auto insurance is pay per mile; that would have a profound impact on how much people drive. It would reduce congestion and reduce greenhouse gas emissions.

Q: Why do we still have the existing system?

There’s a company out there called Metromile which has started to do pay-per-mile insurance. They’re in eight states. A couple other companies are trying it out.

The challenge for companies is that while they are going to lower the price for half their customers they also have to raise the price for the other half. Game theory tells us that once pay-per-mile gets popular enough, the status quo will implode, the reason being that the people who are attracted to pay-per-mile are the ones who drive less. The pool of customers that remain with the existing model will be the ones who drive more. Insurers will have to keep on raising their rates. That ultimately leads to a death spiral for the current system.

Q: When you run into these frustrations, what lessons do you take away?

Here’s an example. Title insurance is one of the world’s great rip-offs. In many other countries, a central registry guarantees that a real estate title is not fraudulent. There’s no need for title insurance.

I started a business with a Yale student to reform title insurance in New York. We could lower the price of title insurance by 35%. That’s a large amount of money. But when it is mixed in with all the other costs of buying a house, we couldn’t get the customer focus on it in a way that made the business work, which was very frustrating.

The problem is that there are entrenched forces making a lot of money. Those businesses find ways around the market, giving Knicks tickets and you name it to the lawyers and everyone else involved in a real estate closing. I guess one lesson is it’s not enough to be 35% better; you must be 10 times better.

Q: Starting a business is risky. What do you look for as a reason to go ahead?

Find a real problem in people’s lives and try to solve it. With Honest Tea, the problem was that there wasn’t a sensible product to drink. Now, you have flavored waters like Hint. You have flavored bubbly waters like Sanzo and Spindrift. None of those existed when we started.

For Real Made, an organic, no-added-sugar oatmeal-and-fruit breakfast brand I co-founded in 2017, the problem was that people are frazzled in the morning as they try to get their kids and themselves out of the house. They don’t have the time to make a healthy, delicious breakfast. We created a life hack where you make breakfast the night before. It’s sitting there waiting for you when you wake up.

They say you have to choose between convenience, quality, and price. Here we could actually give people all three. We produce something better and cheaper than what you would make if you did it on your own. I like the idea of no-compromise solutions.

Q: Does your grounding in the academic theory shape how you approach business decisions?

A lot of people get misled by market research. Early on, Honest Tea lost to Snapple in taste tests. Eighty percent of people preferred Snapple. For most companies, that would have meant they wouldn’t proceed.

But there were many companies going after that 80% of customers who like Snapple, including SoBe, Arizona, Lipton, and Nestea. A lot of people are happy to do “me too.” We saw that we would have the 20% that preferred Honest Tea all to ourselves. I’d rather have a product that appeals to 20% of an underserved market than 80% of a congested market. That isn’t how a lot of companies look at the world.

Q: Looking back, what are you most proud of having done in your career?

After selling Honest Tea to Coca-Cola, I had the opportunity to live anywhere and do whatever I wanted. I’m still married to the same woman, living in the same house, and doing the same job.

In the Harry Potter books, the Mirror of Erised (desire spelled backwards) lets the person looking into it see the life they wish they had. I got to look in the mirror and saw myself. I’m lucky and proud of the fact that my family and my career are what I would wish for.

Department: Faculty Viewpoints