The game maven of New Haven
Yale professor Barry Nalebuff brought game theory from the ivory tower to the executive suite — and to his own thriving company, Honest Tea.(originally published by Booz & Company)
Barry Nalebuff has a hankering for ice cream. Not just any ice cream. He wants a particular organic recipe, developed by a startup with a stall located somewhere in the maze of booths in the Baltimore Convention Center at a trade show called Natural Products Expo East. An economist and professor at Yale University’s School of Management, Nalebuff is also the chairman of Honest Tea, an organic beverage company he started in 1998 with former student Seth Goldman. That role has brought him, in October 2006, to Baltimore to meet with buyers, investors, and distributors. What he seems to enjoy most at the show is his role as booth “hunk” (as his staffers call it) — pouring tea and answering questions from all comers. It’s the kind of thing that clearly goes better with a little ice cream. “Let’s get a snack,” Nalebuff says to a visitor, and he’s off into the chaos of the convention hall.
Honest Tea’s chairman, 48, looks like a stereotypical absent-minded professor, with curly hair sprouting from his head and green-accented spectacles perched on his face. But he is also a hard-edged business analyst. Walking the aisles at the convention center, he stops at every food business he passes to ask questions of the proprietors. What is the sourcing? Who designed the packaging? How is it distributed? Does it taste good? Given an opening, he almost always has a suggestion for trying things differently or looking at a challenge from a new perspective. Meanwhile, between booths, he describes the equity structure of Honest Tea and the debt it owes to the mathematical field called game theory. His references range from Donald Trump to economists James Mirrlees and William Vickrey, who shared the Nobel Prize in 1996 for their work in applying game theory to incentive problems.
Barry Nalebuff is a rare breed: a working economist who also runs a business. He made his name in academic circles with two related ideas. The first was the application of game theory to business strategy. The second was “co-opetition”: a strategic way for managers to work with rivals, balancing the tension between growing a pie together and competing to get the biggest piece. The theme tying together his academic work is the determination to apply game theory to ignite innovation and tackle real business problems — a practice he has pursued in consulting stints with Columbia Forest Products, Eli Lilly and Company, Johnson & Johnson, and General Electric, among many other companies. He is one of the enviable handful of “creativity consultants” corporate leaders bring in to shake up calcified thinking, tease out innovative solutions, or game out the possible permutations of a deal in the offing.
“Barry has this particular intellectual agility that allows him to reduce business problems to their practical essence,” says Lydia Micheaux Marshall, who sits on the board of Nationwide Insurance with Nalebuff and who hired him as a consultant to Sallie Mae. “But at the same time he is able to tie in lessons of economic theory.”
Nowhere has Nalebuff’s creative and practical approach to economics been more deeply integrated into a company than in his own. Both literally and figuratively, Honest Tea puts Nalebuff’s theories on display. For starters, the labels of its lightly sweetened drinks — the products that launched Honest Tea — spell out the rationale for the sugar content, including a chart illustrating the decreasing marginal utility of sweeteners. This little chart educates tea drinkers in the Nalebuff Approach, in which solutions lie in examining problems from new perspectives and calling on economic theory to bolster the response. In other words, how can you get great taste without a lot of calories? Not by eliminating sugar, but by skimping on it. A little sugar adds taste (marginal utility), whereas a lot of sugar adds only calories (declining marginal utility).
You will notice that we did not pick the point on the curve where the flavor was maximized,” Nalebuff says. “The reason was that by backing off the sweetness from there we lost very little in terms of flavor, while saving a good amount in terms of calories.” Honest Tea’s performance suggests that the theory holds water: The slightly sweet beverage is the number one brand in such premium chains as Whole Foods.
The professor brings that same practical approach to the classroom. In his business school classes on negotiation and strategy, he leans heavily on his experiences building Honest Tea into a thriving operation. Meanwhile, he has coauthored three well-regarded books that popularize his approach to problem solving, wherein the ability to achieve good results depends on the ability to recognize marginal gains and probabilistic outcomes. “There are nonbelievers out there who think that game theory is an interesting academic subject that doesn’t have much to contribute to business,” Nalebuff says. “I believe that a game theory perspective has wide applications. A better understanding of game theory can lead to more successful business, politics, and everyday life.”
As suggested by the titles of his books — Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life; Co-opetition: A Revolutionary Mind-set That Combines Competition and Cooperation. The Game Theory Strategy That’s Changing the Game of Business; and Why Not? How to Use Everyday Ingenuity to Solve Problems Big and Small — Barry Nalebuff regards practicality as an absolute requirement for any theory. The most practical ideas are those that serve the greater good by helping individuals observe their environment more keenly. “A key lesson of game theory is to look ahead and anticipate the moves and countermoves of others,” says Nalebuff, while striding through the convention center aisles. “Many of our current struggles in shaping the world come from a failure to anticipate the reaction of others to our strategy.”
Nalebuff stops in front of HappyBaby, a new purveyor of frozen organic baby food. After pronouncing her pears “delicious,” he peppers Shazi Visram, HappyBaby’s founder and CEO, with questions and unsolicited advice. “The challenge with this is that it’s frozen,” Nalebuff says. “Frozen distribution is incredibly challenging, and the hard part for you will be ramping up production.” He gives Visram a contact for a Canadian company that has nailed the manufacture and distribution of frozen foods. The two then moan about the body aches associated with long days at the booth. “We were thinking of holding a yoga class in the aisle,” Visram says. Nalebuff immediately shifts into a one-legged pose, his arms thrust forward. That lasts only a few seconds; then, with a flourish and a smile, he heads down the aisle in search of his ice cream.
Boundaries and Incentives
Barry Nalebuff first visited Yale in the mid-1970s as a prospective student during his senior year of high school. Egged on by friends, he entered the college’s oratory contest, a competition normally confined to Yale undergrads. Never mind that he wasn’t a student there; he hadn’t even prepared a text. He won. Yale offered him admission, but he decided on MIT instead. “I thought I would be a mathematician,” he says. “Then I realized I didn’t quite have it, and the world doesn’t need any more pretty good mathematicians.” He says his curiosity and his facility with numbers drove him to study economics and then game theory, which he pursued at Oxford University as a Rhodes Scholar.
Game theory is the science of interactions. Introduced more than 60 years ago by John von Neumann, the father of modern computer architecture, and economist Oscar Morgenstern, game theory is a mathematical tool used to anticipate possible scenarios and develop appropriate strategies to deal with them. It is based in part on the premise that the decisions made by any players in a game change the nature of the playing field for everyone. For example, a basketball player on a winning streak changes the nature of play for the entire team; the opposition, because it must devote its attention to guarding the star player, can no longer cover the whole court effectively. This in turn gives other members of the star player’s team a better chance of becoming stars themselves. In pure game theory, winning strategies involve learning to understand the mind-set and likely moves of key players, and then anticipating their impact as everyone else reacts. For businesspeople, an effective game theory–based strategy might mean examining all the players in an industry and teasing out how a move in any particular direction will affect everyone else. The British navy pioneered game theory in World War II to help the Allies track German U-boats across the Atlantic. Game theory was later adapted in academic settings to analyze games like poker, football, and chess. (That history was depicted in Sylvia Nasar’s book A Beautiful Mind, about mathematician John Nash, and in the film made from that book.)
From the 1950s through the 1970s, game theorists became increasingly abstract and mathematical, basing their conclusions on equations rather than real experience. Barry Nalebuff set out to reverse that trend and reconnect game theory to the real world. Although it is a widely accepted approach now, extending game theory to business required an intellectual leap. As Nalebuff explains, there are two reasons for that. The first is the original emphasis on “zero-sum” games: For someone to succeed in poker, football, chess, or even submarine warfare, someone else has to lose. “In business, your success doesn’t require others to fail,” he says. The second reason is that there are no explicitly defined rules in business. Indeed, nothing defines the boundaries of a “game,” or even whether the same game is being played by all competitors. And that’s where both the peril and the potential lie. “In business, you can work incredibly hard and your efforts won’t be rewarded if you are playing the wrong game,” Nalebuff says. “But you also have the opportunity to change the game, rather than just play it. Success comes from playing the right game.”
Nalebuff bases many of his ideas on the thinking of Nobel Prize winners William Vickrey and James Mirrlees (published in the late 1940s and mid-1970s, respectively). Their work illuminated how business and government leaders can make decisions on such matters as contracts and taxation even when they’re working with incomplete information. They looked at how different incentives would affect the outcome of decisions. Mirrlees’s work on optimal income taxation led him to change his political views — from the belief that the government should tax the rich heavily to help the poor to the belief that, because taxes affect every individual’s incentive to earn, the optimal rate for everyone should be just 20 percent. Vickrey’s work in “congestion pricing” suggested that pricing on toll roads and commuter transportation should rise during rush hour; this approach has become common for electrical utilities and airlines. (See “Lights! Water! Motion!” s+b, Spring 2007).
According to Nalebuff, in a globalized business environment with instant communication and therefore near-limitless options, game theory provides a way for corporate leaders to consistently make better choices. “Because the world is changing so fast, we can’t count on learning by doing or experience,” he says. “By the time we have moved up that learning curve, we are in a new game. And in the activity of shaping that game, we need to have tools that predict what it is that we are creating.”
But Barry Nalebuff hit a pothole in the late 1980s when he tried to teach game theory. “The students weren’t seeing how it was directly applicable to business,” he says. The 1991 book Thinking Strategically, which Nalebuff wrote with Princeton economist Avinash Dixit, was his response, and a well-received effort to bring game theory solidly into the real world. But Nalebuff wanted to take his ideas further. “I realized Thinking Strategically was sort of like Apollo 13, a successful failure,” he says. Co-opetition, written in 1996 with NYU economist Adam Brandenburger (when both were at Harvard), was a further step, synthesizing research in and out of the classroom to apply game theory to business.
The Game Changer’s Reward
Then, while consulting to Fortune 500 companies in the mid-1990s, Nalebuff developed his method for applying game theory in business decisions. The process begins with writing down and categorizing all the elements of a game: the players, the rules (e.g., laws and government regulations), people’s perceptions, the boundaries of the game (the market), and the linkages among all the elements. With that level of detail in hand, the player then spells out the consequences of a change to any of the elements. The approach helps CEOs make better strategic moves by offering a more complete picture of the consequences of their decisions. More importantly, says Nalebuff, it can help leaders understand the games of their industry well enough to reframe the business. “‘Philosophers have only interpreted the world. The point, however, is to change it,’” Nalebuff says. “Karl Marx said that, and I am probably one of the few professors who still quote Marx, but he had a point: The action is in changing games rather than playing games.”
Consider Holland Sweetener Company — a case that Nalebuff teaches at Yale’s School of Management. In the late 1980s, Holland Sweetener was looking to take a swing at Monsanto’s NutraSweet business. Monsanto’s patent on aspartame, the sweetener in Diet Coke and Diet Pepsi, was set to expire in 1992, and Holland Sweetener invested $50 million to build a plant and enter the aspartame “game.”
But Holland Sweetener was playing the wrong game. Rather than embrace a second supplier and bring it into the business, Coke and Pepsi used Holland’s entry into the market to squeeze Monsanto for a $200 million savings on NutraSweet. “And what did Holland get? Diet Squirt,” Nalebuff says. “I want to argue that that was completely predictable. Coke and Pepsi didn’t want to switch; they wanted to use Holland to get a lower price.”
So what does game theory suggest Holland Sweetener should have done? “They should have gotten paid for changing the game rather than playing the game,” says Nalebuff. “They should have said to Coke and Pepsi, ‘Before we build this plant, give us a contract. And if you are not willing to give us a contract now, why in the world would you be willing to give us a contract after we build the plant?’”
Holland Sweetener also might have asked Coke and Pepsi to help pay for the cost of the plant. Or even bargained for a percentage of the savings that the new plant would make possible. “They failed to see that they had a lousy product to sell in aspartame, but they were a monopolist in selling competition,” Nalebuff says. In short, selling competition — offering Coke and Pepsi new leverage in negotiating deals for its sweetener — was the game Holland Sweetener should have been playing. “Companies are too quick to give away competition,” Nalebuff says. “I want to suggest that competition is valuable. When I take on this activity I know what’s in it for you, but I need to understand what’s in it for me. I want to make sure that I am going to be rewarded for changing the game.”
After the plant opened in the late 1980s, Holland Sweetener lost so much money that the company’s executives decided to exit the aspartame game. But as a last-ditch move, says Nalebuff, “Holland Sweetener went to Coke and Pepsi and said, ‘Guys, we’re about to leave, unless you give us a contract.’ They used that threat to exit to expand the plant. So although they didn’t get paid to play, they got paid to stay.”
For Nalebuff, a company must understand the nature of its leverage in order to understand how to play or change the game. “Before you go through the expense and time, you need to discover in advance how much they value you. When you discover that they don’t value you, you need to do something else. And when you discover that they do value you, then you can change the game to make sure you are going to get more of
Perhaps the ultimate expression of Nalebuff’s drive to popularize his ideas was an episode of the ABC program Primetime that he hosted in March 2006. In one example, six pairs of people, total strangers, had to find one another somewhere in the five boroughs of New York City. By thinking about what the other pair was thinking, they all found each other within hours. Now, Nalebuff and Yale Law School Professor Ian Ayres (the coauthor of Why Not?) are developing a reality television show based on their book about driving innovation. It’s another attempt to reach as broad an audience as possible, but the goal isn’t just ratings, it’s change. “This is reality television with a higher purpose: to improve the world,” Nalebuff says. In each episode, the swashbuckling professors will set out to solve a real-world problem. Viewers will see their process of problem solving, and the implementation of the idea in real time.
The Anti-Dilbert Principle
Barry Nalebuff is standing in front of a roomful of Yalies at a recent alumni gathering where he’s the guest lecturer. Because he’s not working the natural foods crowd, his dress is a more professorial shirt and tie. Still, he is never far from using food to illustrate a point. He picks up a banana. “How do you peel a banana?” he asks the gathering of high-powered financiers, attorneys, and other mover-and-shaker types. A few members of the audience shout out, “From the stem.”
Nalebuff smiles. Holding the banana stem up, he slowly rotates the banana, until the stem points at the floor. “Bananas grow like this,” he says, positioning his thumb over what most people would consider the “bottom” end of the banana and peeling down. “What you will discover is the banana peel comes away in two pieces, there are no strings, you’ve got this built-in handle, and your first bite is perfect.” The crowd chuckles. Nalebuff chews and gives them the punchline. “If you had any doubt this is the right way to eat bananas...” he says, his voice trailing off, as a photo of a monkey appears behind him eating a banana the very same way. “My point is not to teach you how to eat a banana better or get you extra potassium, but to remind you that we get complacent,” he says. “We get into this habit that there is one right way to do things, and often the opposite way might be right.”
The topic of Nalebuff’s lecture is innovation, and it has been the focus of his recent research and writing. His approach is summed up in the 2003 book Why Not? How to Use Everyday Ingenuity to Solve Problems Big and Small. Indeed, since publishing the book, Nalebuff and Ayres have established a two-man media operation, of which their proposed reality television show is just one part. They cowrite a column in Forbes, make joint appearances on NPR, and run a Web site that asks users to offer and modify fixes to problems submitted by other users. Their goal is to shake people and companies from their complacency and cynicism, and to help them generate new ideas. The theme of Why Not? is the power of new ideas to foster new companies, new markets, and ultimately, new games.
“I want to be the anti-Dilbert,” Nalebuff says. “What I want to bring together is this Yankee ingenuity, old-fashioned problem solving, ‘no engineering degree required’ approach. We’ve lost some of this approach — the ‘how can we do things differently and better?’ part. Part of our response has been to hibernate, to go back into our shell. I am suggesting that we are not going to solve our problems that way.”
Nalebuff then describes four essential techniques that he uses for promoting innovation and idea generation in his consulting work and in the classroom. The first is to look at problems from the point of view of a person with all the power and money in the world — in other words, a person without constraints. The goal is to remove the individual’s internal editor, the nagging voice that raises all the reasons not to pursue a new idea, and replace it with the voice of the customer. “Instead of focus groups or market research, look at this customer in your head, look at how they would solve the problem, and then go make it practical.”
What, for example, would Donald Trump do to solve the problem of a fax machine calling your bedroom phone at 2 a.m.? “He’d hire an apprentice to answer the phone for him,” Nalebuff says. “It’s a great solution, but it’s not affordable for us. But who do we know who is up at that time, who can screen our calls for free?” The caller. Nalebuff suggests a simple automated voice response when the call goes through, but before the phone actually rings and wakes you up: “You’ve reached the Trumps. Press 1, and the phone will ring. And it better be good.” As Nalebuff explains, “The fax machine won’t know how to get through, but an important caller will.”
The second approach is to look where incentives are poorly designed, and then correct the problem. Barry Nalebuff brings up the example of Blockbuster Video. When it was founded, the company bought taped copies of movies at $99 a pop from the studios; this meant Blockbuster had to rent out each tape 50 times to recover costs. The result was a shortage of stock, leading to dissatisfied customers who often could not find the movie they wanted. “How do you correct that incentive problem? How do you allow Blockbuster to have lots of tapes?” Nalebuff asks. The answer: “Pay per play, or revenue sharing.” Blockbuster negotiated a deal in which it pays only $10 per movie, but shares $1 per rental with the studios. “Changing that incentive allowed them to switch to guaranteed-in-stock, no late fees, much higher customer satisfaction, and much higher profits,” Nalebuff says. “That switch saved their business. It may not save them from video-on-demand, but as they say, seven fat years are good preparation for seven lean years.”
Turning things upside down is the third technique. Nalebuff can point to countless small shifts, like the banana trick, that can often make big differences. Do you put coffee in your milk, or milk in your coffee? If you do the former, you know the milk gets mixed automatically as the coffee is added. So what? “Dunkin’ Donuts made the switch at its outlets,” Nalebuff notes. “It is able to get rid of countless plastic stirrers and save money.” On a grander scale, Priceline.com took the power to set airline ticket and hotel prices away from the sellers and gave that power to the buyers, building a $1+ billion company in the process.
The fourth Nalebuff technique is asking where else a product or an idea could work. Someone else has surely thought of your idea before you. Has the idea worked in other industries, other countries? What can you learn from other people’s investments? As an example, Nalebuff holds up a Spin Pop. The brainchild of two postal workers, the Spin Pop is a lollipop that spins on its motorized base when you push a button. The two inventors of the motor-powered candy sold it for $15 million — a pretty good outcome. John Osher, who headed Cap Candy, the company that bought the Spin Pop, figured there was more that could be done with it. After walking the aisles of Wal-Mart for inspiration, Osher saw the expensive electric toothbrushes and decided to create a $5 spinning toothbrush using Spin Pop’s motor. Osher later sold it to Procter & Gamble for $475 million, and today P&G is using the same motor to power yet another product, the Dawn Power Dish Brush, which sold in the tens of millions in 2006. “The success in every case was based on finding the right problem that their existing answer had already solved,” says Nalebuff.
“Barry is able to use game theory to quickly dissect the tactics that a particular business uses in the marketplace, and is able to reveal the underlying strategies and motivations for these tactics,” says Howard Weissman, a former Warner-Lambert executive with whom Nalebuff worked on the launch of a diabetes drug. “Working with Barry and his unique approach allows business managers like myself to either preempt a competitor’s next move or at the very least respond to competitors in a way that is beneficial to one’s own business.”
Lightly Sweetened Valuations
Honest Tea has been the one place where Barry Nalebuff has explicitly put all his thinking about game theory into practice. The idea for the company emerged after years of teaching Coke versus Pepsi to his students and ruing the dearth of not-too-sweet options on the market. “I was stuck for 10 years by not having the right product,” Nalebuff says. “I was stalled at mixing orange juice with club soda, or cranberry juice with club soda, but I knew there was a market to serve adults.”
After a 1998 trip to India, where he drank vats of tea, Nalebuff came up with the idea for a lightly sweetened tea that he believed could wedge itself into the ultracompetitive beverage market. Around the same time, Seth Goldman, who had studied with Nalebuff as an MBA student and who was working for a socially responsible mutual fund, returned thirsty from a run in Central Park one day and found himself frustrated that there was nothing to drink that wasn’t sickly sweet. Soon afterward, the professor and student happened to talk; this led to a classic why not? moment, and with $500,000 collected from friends and family, the company was born.
The formula with which Nalebuff and Goldman capitalized the company was pure game theory. Normally, startups have to gin up a valuation for a company that doesn’t yet exist. “Rather than try to defend something that we pulled out of thin air, we created a valuation that was based on our subsequent performance,” Nalebuff says. The early investors came in with a zero pre-money valuation, but the founders got warrants at two times, three times, and five times valuations. Once the stock price doubled, the initial investors would be diluted. Once they had tripled their money, they would get diluted again. They would be diluted one more time when they had received five times their money. Nalebuff had created a contingent valuation. The effective initial valuation ultimately depended on how well Honest Tea did. “The game theory lesson here is that when two sides disagree about something, rather than try to convince the other side that you are right, agree to a bet,” Nalebuff says. “If we did as well as we hoped or expected, then our initial valuation would prove to be high. But if not, then we would not dilute the initial investors.”
To survive as an independent in a fiercely competitive market, Barry Nalebuff has time and again turned to tactics grounded in game theory. For example, whereas most commercial tea producers use crushed leaves and dust to make their products, Honest Tea figured out how to brew its product from whole leaves. When a larger rival came up with its own whole-leaf brewing technology, Nalebuff saw a real threat: That rival, with its superior marketing and sales muscle, was going to grow the pie without cutting Honest Tea in on the growth. By sharing its technology with yet another rival in the form of a private-label arrangement, Honest Tea was able to help grow the pie and enjoy a bigger slice of it. “It allowed us to position the private-label products against a rival’s lineup,” he says. “And prevented them from doing it to us.”
Of course, game theory cannot yield answers to all the challenges that Honest Tea faces. It cannot help in the cutthroat competition for shelf space, for example. As Seth Goldman, the CEO and natural sales and marketing chief, describes it, Nalebuff hit a brick wall when he went to argue with a retailer for more display space for his product. “He has a very rational approach,” Goldman says. “He’ll go to a store and find out we have a product that is selling well for them, and just expect that they’ll understand that they need to carry more of that product.”
That retailers behave irrationally in the face of such logic baffles Nalebuff. “Sometimes people don’t see what is in their best interest,” he says. “You have to work hard to make your business idiotproof — and you’ll still be amazed at what you see in the market. For example, we’ve had stores that don’t put our tea in the cooler because, they say, ‘Your product sells so fast that we’d have to restock the cooler before lunch and we don’t have the staff to do it.’”
Nalebuff is on a roll now. “Barry isn’t always the best person to handle sales,” Goldman says, laughing. “I remember a conversation he had with Yale’s catering services that ended in a lot of phones being slammed.” Still, Honest Tea will ring up about $10 million in sales in 2006. Recent deals with Sam’s Club and Costco and with a handful of large distributors suggest that Honest Tea is poised for growth.
“Economic theory often predicts that the firm with the lowest price or best product will capture the market, but inertia is a powerful force to overcome,” Nalebuff says. “Unless you are vastly better than everything else out there, as a small company, you can never get past the mistakes you make and get noticed enough for people to care about what you’ve done.”
Back at the Honest Tea booth, Nalebuff is simultaneously serving tea, chatting with the husband of a former student, and guzzling Brazilian coconut juice. “This is a fantastic product,” he says, turning the bottle to find the name of the distributor. Nalebuff glances off to the side, and you can see that the wheels are turning. Who are the likely partners? Will the overall market grow? How would it be divided? How would manufacturing happen? Would customers even like it? “I wonder how we could combine it with our tea,” Nalebuff finally says. “Why not?” Why not, indeed.
As with so much in Barry Nalebuff’s world, the question here is, What is the game? And how can you think about it a little bit differently — to give yourself the edge to win?
Reprint No. 07108
Michael V. Copeland (email@example.com) is a senior writer at Business 2.0 in San Francisco. He received a 2006 Business Journalist of the Year award from the World Leadership Forum.