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All “risks” have some “uncertainties”, but not the other way around. A good example from Wikipedia is:

We can be uncertain about the winner of a contest, but unless we have some personal stake in it, we have no risk. If we bet money on the outcome of the contest, then we have a risk. In both cases there are more than one outcome.

As I finish my “SDA Application Portfolio” series I think about the utility of the knowledge gained in this class. It was one of those classes where you are not taught how financial instruments work, how brand management is done, nor how profitability is calculated. There were no formulas to memorize, no equations to be remembered. It did not go into the world of marketers or traders, it did not made me analyze a country’s economic growth, it did not teach me how to increase ROI. Yet, it taught me all that and more.

You may ask – What was this course? How does it fit into the MBA curriculum? How will it help you in the long run? Answers will follow.

This course was called “Strategic Decision Analysis”. It was a course that harnessed the power of analysis and thinking in order to take decisions and increase your chances of success. The course introduced many concepts such as Negotiations, Prisoner’s Dilemma, Voting, and Auctions, among others. But more than that, this course provided insight into how a human mind works and what it thinks. You don’t need to be a CFA, a Six Sigma black belt holder, or a Statistics major to understand all this. All you need is common sense thinking and more importantly what the other person is thinking.

It fits well into an MBA curriculum because it is expected of us to go out and take decisions. Difficult decisions. Decisions that will affect companies, people, nations. Decisions that will alter the way you live, you eat, you sleep, and all that in between. How can you take such decisions and maximize your chances to take the right kind of decisions? Note that when you are taking the decisions there is always someone else taking a similar type of decision. You have one goal – to win in this duel of decision making. Because if you don’t win, somebody else takes all the glory or the pain associated with the decision. This course, in part, was about maximizing your chances to win.

With knowledge comes great power. But also comes with it the “curse of knowledge”. It is dangerous and can be applied dangerously. An incomplete assessment of your own understanding of the knowledge can actually lead to disaster. So it becomes important that we become competent in the use of this powerful knowledge and how we apply it.

The reason I am stressing this is because the knowledge is not just limited to the world of business. Your understanding of six sigma will not make you a great husband, a great father. But this knowledge is different. It spans our daily life and our relationships. Thus it becomes more important to understand the subject matter closely and intimately. The most important piece of this knowledge is – knowing what the other person is thinking. Not what you know and think. Bluntly speaking – you need to drop your ego from the equation to apply this knowledge. You have to stop force fitting because there are ample opportunities to do so. One formula to apply this knowledge is this –> First, you need to drop what you know. Second, know what the other person knows. Third, apply what you know and what the other person does not know. What you know is what you have learnt from this course, from your observations, and from the uncommon common sense that has been bestowed upon you.

Final thought – Always remember – Cooperation is better than defection! It will become all too apparent for you to defect with this knowledge. With this toolkit in hand, you will take decisions that go against the grain of this thought, that of cooperation. Recognize such tendencies, observe your thought process, re-evaluate the knowledge, and then apply it again.

I was hungry the other night and decided to order pizza. When I arrived at the Domino’s site, I was greeted by the graphic above. And a bulb went on.

Fairness principle applied at its best – Order any three (or more) items for $5.55 each. For a family or a group of friends this is a great deal provided we need fairness. Lets look at the distributive principles at work here:

• Parity – Every member is free to choose what they want. Difficult to be jealous of one another.
• Proportionality – 1 order per person or if more than more, proportionally higher price paid.
• Priority – Not applicable in this scenario. Any person can choose any item in any given order.

We, as in SDA graduates at Goizueta, have studied “negotiations” and “auctions” to a certain degree. Some of us have even had advanced training in negotiations. Now Harvard professor Guhan Subramanian has come up with Negotiauctions. According to him there is a strong interplay between negotiations and auctions in real life situations. I certainly felt the truth in his statement, based on my experience in the various assignments during the course duration, and am looking forward to get my hands on the book during my MBA so that I have the time to read and ponder over his thoughts.

On December 9, 2009 (i.e. today) Indian government agreed to create a new state. It will be called Telangana and will be carved out of the current state of Andhra Pradesh (see right image – Telangana is marked in white). The division had been called on by Telangana supporter for a very long time and most recently activities had become quite volatile. In fact, the leader of the movement has been on an indefinite hunger strike for the past 10 days. Finally the government had to give in and accept the demand.

But what is the reason for this uproar? Why do some people want a separate state and not be a part of the larger whole? Haven’t we read than co-operation is better for all players involved? The answer lies in the fairness principle.

Long before, Telangana used to be a separate state. In 1953 the government of India merged the then Andhra state and Telangana state into one big entity called Andhra Pradesh. The reason it was done was because then Prime Minister Pt. Jawaharlal Nehru wanted to create states based on linguistic lines. Both Andhra and Telangana had predominantly Telugu speaking population. He had also appointed a committee to oversee the matter. Even then Telangana did not want to be a part of Andhra. The issue was resources and revenue sharing. From Wikipedia:

The region had a less developed economy than Andhra, but with a larger revenue base (mostly because it taxed rather than prohibited alcoholic beverages), which Telanganas feared might be diverted for use in Andhra. They also feared that planned dam projects on the Krishna and Godavari rivers would not benefit Telangana proportionately even though Telanganas controlled the headwaters of the rivers. Telanganas feared too that the people of Andhra would have the advantage in jobs, particularly in government and education.

The committee hence, rightfully so, suggested not to merge the two states. The central government decided not to follow the suggestion and combined the states. They additionally negotiated an agreement that provided reassurances to the Telangana people as well to Andhra people in terms of power sharing as well as administrative domicile rules and distribution of expenses of various regions. This agreement is known as Gentlemen’s agreement of Andhra Pradesh (1956).

Well, it seems that the “Gentlemen’s agreement” did not live up to its nature and hence all problems began again. This time though, after careful deliberation and discussions, the government of India has decided to split the states back to their original forms.

We have learnt a number of bidding strategies in class and many a times the best strategy in most bidding scenarios is to know the value that you assign to the item being auctioned. It should be true when you are buying a house too. But, do you bid for a house even when there is no auction?

When purchasing a house, your real estate agent may show you a house and will tell you the list price. Typically, you will give a counter-offer which will be less than list price. You will hope that the  owner will either accept or negotiate some amount in between your amount and the list price. In this case you may be assuming that the owner understands prisoner’s dilemma and will act in the best interest of both parties (you and him) and that you will respond accordingly. But in our assumption we tend to forget that there is another player in the game who needs to maximize his returns as well – the realtor. There may be instances where he will drag you into a bidding game without you being aware of the situation. And then, you may get carried away.

One common strategy that realtors employ is that of finding another prospective buyer and them pitching you against them. Psychologically you will be expected to get desperate to win and get the house because you have by now developed an affiliation for it (To understand this concept better, do read my highly recommended Influence: Science and Practice). It is very important that you truly estimate what your ZOPA (Zone Of Possible Agreement) is and what your final limit is.

A good article that talks about such realtor strategies and how to defend yourself against being dragged into bidding, read this article by a real estate agent herself, Alison Rogers.

Number of articles have been written on Amazon and Wal-Mart’s war on book prices this holiday season. Let’s take a different look at the same story and how it can possibly help the economy and the consumers by – increasing the pie.

First, the story. Wal-Mart recently decided to start its own price war, taking on Amazon in the online book market. Wal-Mart began by marking down the prices of ten best-sellers—including the new Stephen King and the upcoming Sarah Palin—to ten bucks. When Amazon, predictably, matched that price, Wal-Mart went to nine dollars, and, when Amazon matched again, Wal-Mart went to $8.99, at which point Amazon rested…From a game-theory perspective, price wars are usually negative-sum games: everyone loses. A recent study found that, if competitors do match price cuts, industry profits can get cut almost in half. (Read more: here)

So the final prices were $9.00 (Amazon) and $8.99 (Wal-Mart). Where is the pie here?

I did some research to find out what exactly is the price elasticity of demand for books. Its a difficult number to calculate and I wasn’t very hopeful until I found this research article. This research intended to determine demand for books and was conducted in Norway. The research took into account number of demographic parameters into consideration. One of the numerous conclusion of the article was:

For our calculations, lets assume that demand is fairly elastic and it is –1.5.

So if the prices fell from $10.00 to $9.00 (say) then prices fell by 10%. Which means the books expected to be sold will increase by 15%. Which in turn means that the revenues will grow from 10X to 10.35X (9 x 1.15X). A value creation of 0.35X or 3.5%. While this number may look small in percentage terms, it is substantially big when we can find the real value of X (in 2006 3.13B books were sold) and substitute.

What Amazon and Wal-Mart have unintentionally done is to increase the total pie (the total revenues that can be earned by them). Yes, the margins may have taken a hit, but don’t we know that NPV is a better measure than IRR.

Do you think this research if conducted and analyzed in the US can change prices in the longer run? Thoughts?

A good analysis on this price war has also been done here.

Some time back I had written a piece about my experience with Atlanta’s transit system – Marta. Recently I had an opportunity (or should I say, misfortune) of travelling on Marta again. Because of current economic conditions Marta had decided to make some changes in its fare structure. And guess what, in my opinion, they took the wrong step. The fare has been increased from $1.75 to $2.00 and if you don’t have a breeze card (that costs $5.00) then you don’t get a transfer. C’mon!!!

But instead of complaining again, I want to look at Marta’s fare structure from a different viewpoint – fairness.

As I had spoken in my last writing, I do not find it correct that Marta charges everyone the same fare. If I have to travel 1.5 miles to school, I pay the same amount as someone who has to travel 15 miles to the other end of the town. It seems that because of simplicity of operational implementation, Marta decided to adopt this fare structure. But I feel that I am actually subsidizing the passenger who wants to travel longer distances. This assessment can be done by looking at some principles of fairness. Is the fair equitable or proportional? Definitely not. Is it efficient? Possible and will require further analysis. Is it envy-free? H**l no! So why does Marta have to adopt such a pricing structure?

Are there other solutions to this problem? Check out fare structure of Singapore’s transit system, one of the best in the world. It has a tiered pricing scheme that works well and hopefully caters to all the fairness requirements much more than that of Marta’s. It is important that Marta plays around with the supply demand curve much more intimately than just moving up the curves.

When discussing game theory, particularly ‘Prisoners Dilemma’, an oft cited real life example is that of carbon emissions control by different nations. Many treaties, agreements have been signed in order to reduce harmful carbon emissions in order to prevent global warming, but without much results.

The time is ripe again to discuss the game in the same context. Barack Obama is planning to visit Copenhagen next month as a show of US’s commitment in efforts to cut down emissions. In the last Kyoto Protocol, US was the only country (among participating countries) that did not ratify the agreement. It is expected that Barack’s presence and commitment will change all that. The article says:

The United Nations’ top climate negotiator, Yvo de Boer, said Mr. Obama’s participation in the summit is "critical to a good outcome."

Assume for a second that US does agree to participate ‘actively’ in reducing carbon emissions, what can go wrong? The answer may lie in the Prisoners Dilemma. Up until now, this game was played among nations sans US and there was an incentive to cheat and not conform to the requirements. As such, countries that did not follow the guidelines were able to extract some benefits that accrued from steps taken by responsible countries. If one of the responsible ones was in fact a large one, the actions by smaller countries were not necessarily taken seriously and the gross impact was negligible. But the net impact, sum of many small countries defecting, was huge. As a result these protocols have not been very effective in curbing the emissions problem so far. See the figure to explain the situation. Note that the numbers are figurative and do not indicate any absolute values.

Now with the entry of US in the fray, the incentive to cheat by the smaller countries will actually increase! Because of US’s commitment, India and China (largest developing nations) will come under much more questioning than before. The result of this would be that these countries will start taking ‘baby’ steps to counter some of the retaliation. As a result of this, the smaller nations, in Africa, the EU, Australia will have an incentive to defect or at least reduce their commitment towards reducing carbon emissions. A lot of focus will be on the actions of more prominent countries, and steps taken by them will have a noticeable impact on the saturation level. Because smaller countries will tend to ‘free ride’ on the steps taken by bigger countries, they will probably reduce their efforts.

Are we forgetting something? Yes. This game is played repeatedly, not once. So don’t all countries have an incentive to co-operate, rather than play truant. From a bird’s eye view, yes. But the assertion can be justified only if we can properly understand the impact of retaliation by the responsible countries in the next round. What kind of punishment is imposed, in terms of sanctions, fines, etc that can prove to be a higher cost that co-operating. The problem facing the planet is grave and hopefully a situation will not play out where both players defect. But the defecting countries can be made to follow is by altering the only variable available for manipulation – the payback for defection.

eBay, as we all know, is the most popular auction site where people put their items on sale. The auction strategy, that allows for proxy bidding, makes the auction second-price, sealed bid rather than English. People who are interested in the item bid for it in small incremental amounts and when the time is up, the person with the highest bid gets the item (provided he has met the reservation price limit, if there is any). As we would typically expect, people bid in small increments deciding to up the price until they reach their estimated value of the item. But most of us get fooled by some ingenious smart person who is waiting until the last second to up his ante and thus snatch away the item from below our nose through a process known as sniping.

In comes Swoopo with an interesting bidding strategy. You actually pay for the bids ($0.60). Note that in these auctions an item is ultimately sold at prices much lower than the retail price (after all, your total price paid includes the money you pay for bidding). But the sellers, the site owners themselves, are here to make a profit. How are they able to do that? One other change from the eBay style bidding is that once you place a bid, the window for bidding increases(by 10 seconds). Sometimes the owners make a profit on an item, sometimes a loss. But overall these people claim to make a profit. Let’s see two examples:

Here, we see that an item, priced at $659, is sold for $5.01. So did the seller make a profit or a loss? This was a penny auction, that means that you can only bid a penny more than the last highest bidder. So $5.01 means 501 pennies which translates to $300.60 earned just through bids. Total money earned by the seller = $305.61. Even if the item was purchased at a 50% discount ($329.50) the seller loses $23.89. I am being conservative in estimating the cost of the item to the seller. Note that these sellers buy items in bulk and get a significant discount.

In the second case (view graphic on the right) we see a different story. Say, the average bid increase was $0.60. So, there were about 206 bids made that earned Swoopo $123.84. Add to that the price paid by the winner which makes the total earnings = $247.68. In this lets say the cost to the seller was 75% of the product price, i.e. $209.25. He has made a profit of $38.43 (higher than the previous loss).

In the end, Swoopo does seem to end up making a neat profit out of its auctions. There is one more thing worthy of pointing here. One of the compliance tactics mentioned by Dr. Robert Cialdini in his book, Influence: Science and Practice, was that of extracting a commitment. In this case, once a bidder pays for a bid, he/she becomes emotionally attached to winning the bid that results in him bidding again and again. His commitment increases, either until the end, or to the point where he really sees where he is headed in. This is like negotiating with oneself – “Just one more bid, then I will stop”. A person should have his BATNA known so that he can stop bidding when the time is right.

I am not done yet. A new site has just sprung up – BigDeal.com. They will actually pay you back the amount you used for bidding, if you lose the auction. Well, how do you think they will make money? The answer may lie in the commitment tactic. You have just become more committed to winning and will bid much higher.