Sunday, March 27, 2011

Back at Harvard, day 1

This blog is going to have an unusual start.  This week I'm lucky enough to be participating in an advanced negotiations course for business executives at Harvard Business School.  I decided to start off by sharing the key thoughts or experiences of each day.  It's quite likely I won't be able to keep up with blogging a full day's work each evening but I'll fill in the blanks where necessary.

Tonight began with one of my favorite illustrations of poor human decision-making: an auction of a $100 with the following rules:

1. No speaking by anyone other than the auctioneer.  All you're allowed to do is bid or sit quietly and wait.
2. The first bid must be exactly $5.  All subsequent bids must be exactly $5 higher than the prior bid.
3. You can't bid twice in a row.
4. The highest bidder gets the $100 in exchange for his bid.
5. The second-highest bidder gets nothing but must still pay his bid.

There are about eighty people in the room.  Would you bid?  If so, where would you stop?

Most of us sat it out (myself included!) but quite a few people bid and new people jumped in at various times.  Finally the inevitable happened...all but two people dropped out and they were trapped.  If you've bid $90 and someone else bids $95 you have a very strong incentive to bid $100 because your net loss is currently $90 and if your $100 bid holds up you break even.  The problem, of course, is that the person who bid $95 has the same incentive to bid $105 so you'll keep going until finally someone decides to cut their losses.  In our class that happened at $130, but auctions of this kind can run into the thousands of dollars once people decide that they may be losing money but they're not going to lose the auction!

After dinner we were presented with the following exercise:

In an industry with two co-leaders (i.e. two leading companies of roughly equal size), a medium-sized company (we'll call it "Prize") announces that it's for sale.  The following assumptions are given:

1.  The value of Prize as an independent company is $1 billion, but due to synergy it's worth $1.2 billion to either of the co-leaders.
2.  It's bad for either of the co-leaders if the other one acquires Prize because then they fall to #2.  This would reduce their value by $0.5 billion.

You're the CEO of one of the co-leaders.  What do you do?

Let's start with the math.  Prize is worth $1.2 billion to you, but just like in the dollar auction the CEO of the other firm has an incentive to bid more than it's worth because there's a cost to losing the auction.  If you have a bidding war the winner is likely to pay close to $1.7 billion, at which point each of the co-leaders has lost $500 million in value.

I'm embarassed to admit that although I saw the correct goal (don't bid but also convince the other co-leader not to bid) but wasn't able to think of a way to achieve the goal that wasn't illegal.  Once either company bids the other one is forced in, so their best result is for neither to bid.

As it turns out, this hypothetical was based on a real situation -- the U.S. airline industry when USAir announced that it was for sale.  American and United, the market leaders, were quickly identified as the likely buyers and Bob Crandall (who was in charge of American Airlines) recognized the danger of a bidding war.  His solution?  He sent a memo (a physical memo, not an email) to every single employee of his airline, down to the baggage handlers, explaining that American Airlines did not intend to bid for USAir but that if United did decide to bid for it, American would be forced to defend its position in the market.

As you can imagine, with that many memos printed one of them found its way to United Airlines.  Neither airline bid for USAir.

3 comments:

  1. Hi Chad,
    this is Rada.

    I understand if you don't have time to explain this, but a lot of this stuff is very new to me and seemed cool so I looked up the things that were confusing; but I can't find what it means when something is worth more due to synergy.

    Even if you just link me to some wiki page that'd be awesome.

    Good stuff!

    Thanks
    R

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  2. In this case, synergy means that if you merge two airlines you can eliminate duplicate functions (redundant sales operations, ticket counters, gates that aren't used all the time, etc.) and save money over operating the two airlines separately.

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  3. The case study reminded me of a Paul Harvey, "...and now you know...the rest of the story."

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