The ongoing discussion of Game Theory based on the book Co-opetition
When we ask about changing the game, the first thing people usually think of is changing the rules. But if we ask what rules you might change or how you might go about changing them, the question often seems perplexing. After all, most of the rules business people play are well established laws and customs. They have evolved to help ensure that trading practices are fair, that markets keep operating, and that contracts are honored. To step outside these rules would be to risk legal penalties or exclusion from the market.
But there are other rules of the game that it can make sense to change. Many of these rules are the ones found in contracts. Your contracts with customers, employers, employees, and contractors shape your interaction with these players in ways that extend far into the future. A single clause can tilt the balance of power heavily toward you or against you. By shaping your relations, these contracts will also shape your relations with competitors. To be sure you are in a game where you’ll make money, you have to make sure you’ve got the right rules in your contracts.
What all these more negotiable rules have in common is that they involve “details”. Compared with changes in players or in added value, these possible changes in rules can seem like a small scale matter. Relatively small changes in the rules of business can produce enormous changes in outcomes. In other words, where business rules are concerned, the details are everything.
Contracts with Customers
You and your customers are partners in creating value, but it’s not all cooperation. When your customers press you for price concessions, that’s competition.
Let’s look at how to use rules to change the game with your customers. Because rules alter the balance of power, you can use them to restructure negotiations to your benefit. Of course your customers will also be trying to change the rules to put themselves in a stronger position. But the immediate goal is to develop a clear understanding of how rules change the game.
Most Favored Customer Clauses
A Most Favored Customer clause (MFC) is a contractural arrangement between a company and customer that guarantees the customer the best price the company gives to anyone. The MFC prevents a company from treating different customers differently in negotiations. Other common names for this rule are “Most Favored Nation” or Best Price Provision”. MFCs are common in business to business contracts. Customers like the price insurance feature. With an MFC in place, the customer is guaranteed never to be at a cost disadvantage to any competitors who buy from the same supplier.
MFCs sound like a good deal for your customers, but what do they do for you ? Brandenburger and Nalebuff use a card game to illustrate how an MFC might work. In their game they have a deck of 52 cards, the authors hold the 26 black cards and their 26 MBA students each hold a red card. The authors receive $100 every time they complete a pair of black and red cards. So they must negotiate with each student to obtain the student’s red card and complete the pair.
Before the game begins, one of the students, Dan, announces that he has to leave to compete in a mountain biking event. No problem, the authors promise Dan that he’ll get the best deal given to any other students – they give him an MFC. Dan rides off knowing he has the best deal of all, and he doesn’t have to work for it.
Even though Dan will get the best deal, he might be surprised at what the deal turns out to be. The author’s contract with Dan is going to make them much tougher negotiators with each of the other students. Let’s look at the first of these negotiations with Barry, the smartest guy in the room. If Barry pushes for an extra dollar, that costs the authors a dollar right now. But the concession also costs the authors another dollar when Dan returns from mountain biking. Whenever the authors makes a new concession of a dollar to a student, it costs them two dollars. The bargaining is not symmetric. The authors will push twice as hard as the student does. They will be braver and more aggressive negotiators. Consequently we expect the authors to end up with more than half of the $100.
It’s more or less the same story with every one of the remaining students with whom they negotiate. Even though Dan is not in the room, his presence is felt in every negotiation. All students will get a worse deal and that includes Dan. When he returns from mountain biking he’ll be quite disappointed to see how the card game played out.
MFCs are counter intuitive in their effects. The natural guess is that customers do better with the protection of an MFC, and they would if MFCs didn’t change the game.
When your customers have MFCs you’re more able to withstand pressure to lower price. You can point out that a price concession to one will become a price concession to all of your customers. MFCs are an instance of “strategic inflexibility”. People often thinking having more flexibility is one of the universally good things. Sometimes you have more power when your hands are tied.
If MFCs help the seller capture more of the pie, why do customers go along with them – even press for them? One reason is that some customers simply don’t get it. They don’t realize how an MFC changes the game. Which is not surprising, considering that MFCs influence is rather subtle, even counterintuitive. A second reason is that customers recognize they are poor or at best average negotiators. They do better taking the lowest price anyone else negotiates, even if MFCs lead to higher prices overall. Third, MFCs don’t always lead to higher prices. If the seller is forced to give a customer very generous terms, everyone else will be given those same terms.
Corporate customers have another reason to accept, even desire an MFC. A corporate customer may be less concerned with absolute level of prices than finding themselves at a cost disadvantage to their competitors.
What ultimately makes MFCs so effective in changing the game is the subtle way in which they enable a seller to take control, almost in a backdoor fashion. By giving out an MFC to one customer, you change the game for everyone else. Because when you negotiate with someone else, whether or not THEY have an MFC, you will be a tougher negotiator because of your other customers with an MFC.
One drawback of giving out MFCs is that doing so makes it harder to keep your cusomers. A competitor, knowing that your customers have MFCs, might be all the more tempted to go after them in the first place. They recognize you are unlikely to match a lower bid, when it would affect all of your customers, not just the one they are targeting.
A second drawback is that it becomes more expensive for you to go after a rival’s customers with a lower price, because you will have to give the same price to all of your existing customers.
Next Time – Meet the Competition Clauses