IN THEORY, THE DIGITAL ECONOMY IS A LOSING GAME

Two criminals are arrested on a minor charge, detained and separated. The police suspect they are involved in a more serious crime than the one for which they were arrested and are hoping to convince at least one to give the other up. Both criminals are given the same choice: confess and serve a lesser term of imprisonment for the minor crime, or implicate the other in the more serious one and go free. Whoever is betrayed will serve a longer term for the more serious crime. The prisoners have no way of knowing if the other will betray him or stay silent.

If both stay silent they each serve the shorter term. If one betrays the other, that person is free while the other serves the longer term. If both betray the other, they will both serve the longer term. Seeing as there is no scenario in which both can go free, the best option is for both to stay silent. The only problem is each has no way of knowing if the other is going to make that ‘rational’ decision, or sell the other out in a bid for freedom.

Many of you will recognise this story as the prisoner’s dilemma, the classic example to illustrate the concept of game theory. Game theory is defined in Wikipedia as “the study of mathematical models of conflict and cooperation between intelligent rational decision-makers“.

Game theory applies to situations where two or more participants are faced with choices of action. Every choice will result in either a win or a loss depending on what others choose to do or not to do. The key considerations in decision-making are how co-operative and how rational the other parties will be. The final outcome of the ‘game’ is the total of all the strategies chosen by all participants.

Businesses regularly make decisions using game theory even without realising it. For example, what happens if I raise my prices but others don’t? I could make more profit per transaction, but also lose market share. Or, what happens if I stockpile to mitigate risk of shortage? If other don’t stockpile and there is shortage, my investment pays off. I win, they lose. If I stockpile, others don’t and there is no shortage, I have invested unnecessarily. They win, I lose. If I don’t stockpile and others do and there is a shortage, they win, I lose. If there is a shortage and no one stockpiles, everyone loses. You get the picture.

Game theory talks about the zero-sum and non-zero-sum game. Zero-sum means a win by one party comes from the loss of another. Poker is a zero-sum game. The wins of one player exactly equals the losses of the others. The stock market is a non-zero-sum game; the wins of one investor does not mean other investors have lost.

The positive sum game

In the world that was the 20th century, we relied on the game always being positive sum, that is, when the wins and losses are tallied, the overall result will be in the positive. The prospect of endless growth offered a win-win for companies (the chances of a win were greater than a loss) and for customers (who had the luxury of more choice).

In a positive sum game, more of the same businesses could open because the net wins were greater than the losses, so the risk was worth taking. However, the continuous stream of new entrants resulted in saturated markets. As growth could be achieved through good execution and improvements, there was little incentive for incumbents to innovate.

As we head into the 21st century, we are forced to acknowledge that endless growth is a myth because our ability to consume is limited, if not by our decreasing desire for material goods, but by the earth’s available resources.

…Turns into a loss

The digitisation of business has created a negative sum game as goods and services become increasingly commoditised. With greater access to choices, it becomes harder to differentiate between offerings from different sellers. Buyers become less concerned who they buy from. Sellers lower their prices to remain competitive. This reduces sellers’ abilities to invest in innovation, research and development, and developing unique features. The commoditised market is a lose-lose, for the company (whose profits are squeezed) and customers (who have fewer genuine alternatives).

We see this in the airline industry, for example, where commoditisation of economy travel gives everyone a less comfortable flying experience. Even those customers who don’t balk at paying extra for meals, entertainment, and other amenities will have less room. Everyone is worse off overall than before.

Consulting firm McKinsey recently looked at the impact of digitisation on industry. In the recent article, The Case for Digital Reinvention, researchers examined companies in different industries to forecast the impact of increasing digitisation. Their conclusion – everything else being equal, digitisation is a negative sum game. As industries digitise, overall revenue and earnings fall.

The research took the current rate of digitisation (37 per cent) across all industries and analysed its impact on companies’ revenue and EBIT (both falling in line with increased digitisation). They then extrapolated the data to model the impact on industries as they move closer to full digitisation. The result was overall decreasing revenues and lower earnings growth due to the downward pressure digital competition has on business and profits.

However, the results would be far from even.

“Bold, tightly integrated digital strategies will be the biggest differentiator between companies that win and companies that don’t, and the biggest payouts will go to those that initiate digital disruptions. Fast-followers with operational excellence and superior organizational health won’t be far behind.”

It will not be a case of high gains for the bold, and business as usual for the laggards: “…economic performance is extremely unequal. Strongly performing industries are three times more likely than others to generate market-beating economic profit. Poorly performing companies probably won’t thrive no matter which industry they compete in.

Growth through digitisation will come not from overall available growth but from cannibalising the competition – negative sum game.

Using game theory: industry players can all choose to co-operate, and no one digitises in order to prevent total available revenue from shrinking. That is the best collective option. However the companies that choose not to co-operate will have a major advantage. Their growth will not only cost the slow companies their business and shrink the overall revenue pool, but their individual gain could be three times greater than everyone else.

Unlike the prisoner’s dilemma where a possible scenario was both prisoners doing nothing to achieve the best collective result (both serve the least time possible), there is no possible scenario in the market where all firms will co-operate to not digitise in order to keep the overall pool of revenue higher and avoid extinction of the weakest. Proactive firms will seek their early advantage (win), reactive firms will wait, and lose.

It leaves only two options for the sustainable company: invest enough in digitisation to disrupt or lead; or learn to follow quickly. Avoid the bottom of the pile at all costs.

The part that is still to be written is how large the differential will be between the top and the bottom. Based on current trends, the gap will be large. Negative growth, industry turbulence, unpredictability of competition – it all sounds depressing and confusing. But it doesn’t have to be.

Culture is the ace

Digital transformation begins in a very familiar place: the organisational culture. Say the authors of the report:

“A strong organizational culture is important for several reasons: it enhances the ability to perceive digital threats and opportunities, bolsters the scope of actions companies can take in response to digitization, and supports the coordinated execution of those actions across functions, departments, and business units.”

By starting with the culture, companies clarify their brand position in the market and how they intend to offer value to their customer. It then forms the basis for the company’s people to pull together to work through how to do business differently. Digital transformation becomes a people process as much as it is a technological one.

Winning, then, is ensuring your organisation is ready for digital innovation. Losing is sticking to current business processes. There is no dilemma – only winning or losing.

Let the game begin.

 

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