MBA Programme – Part Time

A Game Theory Perspective

on the Personal Computer Industry

Individual Assignment

Module: Games and Strategies for Business (N1DM51)

Module Lecturer/Facilitator: Robert Hoffman

Submitted by:

Wong Shoon Hooi (001396)

Date: 20 May 2005

Word count: 2262

© 2005 WONG SHOON HOOI 1

Introduction
Ever since the launch of the first IBM Personal Computer (PC) in 19811, PCs have become central
in our lives and have created household names of many successful companies in the PC industry
such as Compaq, DEC, Dell, Gateway, HP, Intel, IBM, Microsoft, etc. Along the way, some of
these companies have created dominant market positions (Intel, Microsoft) while some struggled
and were acquired (DEC, Compaq) and others are still ‘struggling’ along (Gateway, HP). IBM
managed a successful turn-around while Dell became the leading PC company in terms of market
share.

The purpose of this paper is to use Game Theory to model and analyze the various ‘games’ being
played in the PC industry to predict the outcomes, explain the situations and/or recommend the
appropriate strategies in the marketplace. These insights can be applied in other high-tech, fast-
growth industries as well.

Game Theory
Game Theory provides a mathematical model to study situations of strategic interdependence
where there exists varying degree of conflict and cooperation. Game theoretic concepts apply
whenever the actions and the outcomes of these actions are interdependent among several agents.
These agents may be individuals, groups, firms or any combination of these. The concepts of game
theory provide a ‘language’ to formulate, structure, analyze and understand strategic scenarios.

Games can be classified according to five ‘rules’ – players/agents, actions/strategies,

outcome/payoffs, information and communication. For the purpose of this paper, only 2-player
non-cooperative (no communication or no enforceable agreements) games are used.

There are two major types of non-cooperative games: sequential and simultaneous. In a sequential
game (game of perfect information), there exists a strict order of play; one player makes a move
and the other has a chance to study it before reacting. This creates a situation where one player
makes a move in consideration of future consequences. A simultaneous game is one where both
players make decisions independently without knowing what the other player’s actions are or what
they will do (game of imperfect information).

1
Apple, Atari, etc. have launched their personal computers prior to 1981 but IBM created the first ‘open architecture’ PC platform.

© 2005 WONG SHOON HOOI 2

One of the key underlying assumptions in Game Theory is that of rationality which states that
“When faced with several courses of action, people usually do what they believe is likely to have
the best overall outcome” (Jon Elster, 1989). A rational player will choose an action which gives
the outcome he most prefers (utility/payoff maximizer), given what he expects his opponents to
do. In certain situations, an assumption of bounded rationality is applied where routine standard
procedures or heuristic approaches to decision-making are employed.

The solution concept employed to predict and/or explain what players will do in a given game is
equilibrium analysis. In equilibrium, no changes in behaviour are expected as players are assumed
to use their equilibrium (rational) strategies to maximize their respective payoffs. Sequential
games are represented in the extensive form (game tree) and solved through backward induction
(rollback analysis). Simultaneous games are represented in the strategic/normal form as a payoff
matrix. One can start with the Dominance approach (through the iterated deletion of dominated
strategies) and/or the Nash Equilibrium approach (through cell-by-cell inspection) to locate any
equilibrium where each players are playing their best reply in response to one another.

Game Analysis: Microsoft and Intel

Microsoft and Intel controls more than 90% market share in PC operating-systems and micro-
processors respectively. Their dominance was built over the years when IBM decided to use MS-
DOS as the operating-system and Intel 8088 as the micro-processor for its first PC in 1981.

The following assumptions are made:

1. It is a non-cooperative game as there weren’t any exclusive and enforceable agreements
between them as Microsoft operating-systems also run on AMD, Alpha and MIPS
processors; while Intel processors support other operating-systems such as Netware,
Solaris, Linux, etc.
2. It is a repeated one-shot simultaneous game as they introduce their operating-systems and
processors according to their own product cycles. Each introduction can be treated as an
individual round and independent of previous rounds.
3. Actions available for both players are Coordinate and Don’t Coordinate in their product
development and marketing efforts.

© 2005 WONG SHOON HOOI 3

 4. Payoffs are ranked (higher number is preferred) as follows:
a. Both favours coordination as it allows them to ensure that their products work well
together, quicker time-to-market and minimal support issues. (1,1)
b. When one player tries to coordinate and the other player does not, the player
coordinating spent unproductive time and resources (-1). The other player does not
incur any cost at all (0).
c. When both players do not coordinate, neither player incurs any costs (0,0).

The strategic-form representation is as follows:

Intel
Coordinate (p) Don’t Coordinate (1-p)
Microsoft Coordinate (q) 1,1 -1,0
Don’t Coordinate (1-q) 0,-1 0,0

Solving for equilibrium, neither player has any dominant strategy and there are 2 pure strategies
Nash Equilibria at (1,1) and (0,0). Solving for Mixed-Strategy-Equilibrium, there is one MSE
when p=0.5 and q=0.5 where each will be indifferent to the other player’s strategies.
p+(-1)(1-p)=0 q+(-1)(1-q)=0
p=0.5 q=0.5

However, it can be seen that both players will gain higher payoffs if they play
(Coordinate,Coordinate) instead of their respective MSE strategies. All they need to do is for either
one to ‘signal’ to the other player the desired outcome, if it is not obvious already. This game is
known as an Assurance Game as there is perfect alignment of interest without any conflicts. In
such a game, no enforceable agreement is required as the (Coordinate,Coordinate) outcome is a
Nash Equilibrium which is self-enforcing. It is also Pareto-efficient and Hicks-efficient – it has the
best collective outcome.

The predicted preferred outcome (Coordinate,Coordinate) helps explain why Microsoft and Intel
have been so successful. Through their coordination, they have created the de-facto “Wintel”
standard. Its mass adoption by other computer manufacturers has undermined ‘proprietary’
offerings from IBM (PS/2 computers), Apple (Macintosh), etc. Microsoft and Intel have created a
virtuous cycle which is self-reinforcing; resulting in greater demands, greater applications
availability and better cost-competitiveness. Both players recognized that they are better off
coordinating their efforts.

© 2005 WONG SHOON HOOI 4

Game Analysis: Dell and Compaq
Dell is the current market-share leader while Compaq was the leader in the mid-1990s. Compaq
created history by reaching the Fortune-500 list and surpassing US$1 billion in revenue faster than
any other company. However, with the advent of the Internet in the mid-90s, Dell has aggressively
gained grounds with its direct business model, which reportedly has a cost-advantage of 14% over
Compaq and ultimately usurped the No. 1 crown from Compaq in 2001 after a series of price-war.

The following assumptions are made:

1. It is a non-cooperative game as there weren’t any enforceable agreements between them
as they were competing with each other in the marketplace.
2. It is a repeated one-shot simultaneous game as both players were driven by quarterly
performance or they would face the ‘wrath’ of their shareholders and analysts. As such,
they would decide on their pricing strategies independent of one another and of previous
rounds. However, Compaq is mindful of Dell’s reputation as an aggressive price-leader.
3. Actions available for both players are Maintain Price and Undercut Price.
4. As Dell has better cost-advantages, the payoff for Dell would be higher than Compaq in a
similar situation. Payoffs are ranked in order of preference (lower number is preferred) as
follows:
a. The most preferred outcome by both players is where one undercuts price while its
competitor maintains price.
b. When both players maintain prices, there is no change in the status quo (market-
share and profitability).
c. When both players undercut prices, the market-share remains the same but Dell
will gain more due to its cost-advantage.

© 2005 WONG SHOON HOOI 5

 As such, the preferred outcome for Dell and Compaq are as follows:
Dell Compaq
1 Dell undercuts, Compaq maintains Compaq undercuts, Dell maintains
2 Both undercuts Both maintains
3 Both maintains Both undercuts
4 Compaq undercuts, Dell maintains Dell undercuts, Compaq maintains

The strategic-form representation is as follows:

Compaq
Maintain Price Undercut Price
Dell Maintain Price 3,2 4,1
Undercut Price 1,4 2,3

Solving for equilibrium, both players have Undercut Price as their dominant strategy resulting in a
Dominant-Strategy-Equilibrium at (2,3) which is also Pareto-efficient. There is no common
interest at all and both players are in constant conflict. This is not a repeated Prisoners’ Dilemma
game as there is no room for cooperation at all.

The predicted outcome (Undercut,Undercut) explains why Dell was aggressive in its pricing.
Dell’s COO James Vanderslice (25 May 2001, CNN) declared an all-out price war in a push to
gain more market share and potentially drive competitors out of business. Compaq, in order to
maintain its market-share position, and without a better strategy, has no choice but to join in the
price-war (playing its best-reply), even though it is not in its best interest to do so in the long-term.

Compaq was at the losing end due to its price disadvantages. Compaq did make some strategic
moves to try and change the rules of the game. It tried to change its payoffs through its Compaq
Direct online initiative, hoping to achieve Dell’s efficiency. However, due to its business model of
relying on distributors and resellers and the immediate negative impact on its business should it go
direct, Compaq was never able to bring its payoffs inline with Dell’s. This helps explain why
Compaq made other strategic moves to acquire Tandem (1997) and DEC (1998), hoping that it
can ‘play’ another game in the enterprise computing space (changing players) where margins
(changing payoffs) were much healthier. However, in this fast-pace industry, Compaq did not
have the luxury of time for its strategy to work out as Dell continued charging ahead. Compaq was
eventually acquired by HP and now HP is caught in the same game with Dell.

© 2005 WONG SHOON HOOI 6

Strategic Moves: Dell and IBM
Dell
With its initial success in PCs, Dell made some strategic moves and expanded into other ‘games’
(business segments) – such as Enterprise Products and Services in 1998 (partnering with EMC
against players like HP, IBM, EDS, etc.) followed by Printing and Imaging in 2003 (partnering
with Lexmark and Fuji/Xerox against players like HP, Epson, Canon, etc.).

Dell once again proved that it can execute its strategies flawlessly to deliver an impressive result
where Printing and Imaging commanded an 11% worldwide market share in inkjet printers after
just over a year into the business. Dell has also changed the ‘rules’ of the game by incorporating
pro-active ink-usage tracking software and providing free recycling of empty cartridges,
effectively increasing its ‘payoffs’ through a ‘lock-in’ effect.

Dell Services has also successfully ‘commoditized’ certain services and won over major customers
like AXA, Boeing, Ford and JP Morgan with a run-rate of US$3 billion annually as of May 2004.

IBM
IBM, the creator of the first IBM PC and the world’s largest IT company have decided to exit
(changing strategies) the PC game completely in December 2004 when it sold its PC business
unit to Lenovo of China. However, IBM has taken other strategic moves earlier to focus its
business on IT services (playing another game) under then CEO, Lou Gerstner when he joined in
1993. This strategic move proves to be important as IBM turned around from a record loss of
US$8 billion (1993) to a profit of US$8.4 billion (2004). IBM Global Services revenue
contribution grew strongly from 25% in 1992 to 48% in 2004. It acquired PWC Consulting for
US$3.5 billion in 2002 to create the world’s largest IT services organization, with more than twice
the revenue of its nearest competitor.

© 2005 WONG SHOON HOOI 7

Conclusion
Through the application of Game Theoretic concepts, models of the strategic interdependence
among the various PC industry players were used to predict their behaviour and identify the most
likely outcomes. The predicted outcomes matched with reality and helped explain the events that
took place.

In the assurance game, Microsoft and Intel demonstrated that through a coordination of efforts,
they are able to maximize individual as well as collective payoffs, without the need of an
enforceable agreement. Both understand this important ‘truth’ and have coordinated in other
industry-standards setting efforts such as USB, PCI, etc.

In the price-war game, Compaq might have taken different strategic approaches in halting Dell’s
move instead of engaging in a series of price-war that left it ‘battle-weary’ and ultimately led to its
demise as predicted in the game theoretic model. Between 1994 and 1997, Compaq was at its peak
with revenues of US$14.8 billion (1995) and US$24.7 billion (1997) versus Dell’s revenues of
US$3.5 billion (1995) and US$7.8 billion (1997). Compaq was 4.2 times and 3.2 times the size of
Dell in 1995 and 1997 respectively. Could Compaq used its bigger size then to stop a charging
Dell? Compaq’s strategic moves in acquiring Tandem (1998) and DEC (1999) was a bit too late
and left it straddling in different games of which it has no competitive advantage.

Lastly, we noted how Dell perfectly understands the game it is playing and executing its strategies
by leveraging on its competitive advantage and changing the rules (typically through
commoditization) of the games it entered. IBM realized early it was playing a losing price-war
game and ceded the consumer PC market earlier before ultimately selling off its PC business to
Lenovo to play the IT services game where it is now by far the largest IT services organization in
the world.

These lessons and strategies can be applied to other industries, especially in high-tech and fast-
growth industries like telecommunications, consumer electronics, etc. where standardization is the
‘name of the game’. By taking a pro-active approach in analyzing a game, one can be prepared
to execute the right strategy, and if need be, to make strategic moves to change the rules of the
game.

© 2005 WONG SHOON HOOI 8

Bibliography
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14. HP website at www.hp.com
15. Intel website at www.intel.com
16. Microsoft website at www.microsoft.com

© 2005 WONG SHOON HOOI 9