Wednesday, March 30, 2011

Class #17 Highlights

The Weakest Link in Cooperation

In this class, we reviewed the results of the OPEC game. The main lesson of this game is to provide practice in achieving cooperation in difficult environments. The two main difficulties in this setting are: (1) lack of observability; and (2) limited tools for punishment and reward. As we saw in GE v Westinghouse, these are common obstacles in many settings.

How do we solve this problem?

1. Limit the temptation to cheat. While both markets sought to hit the joint profit maximizing output quotas, this may be less effective than a less ambitious strategy. By raising the quota, the temptation to cheat is reduced. Ratcheting the quota in steps then creates the possibility of building trust over time.

2. Limit the size of the problem With so many parties to coordinate, the problem is daunting. Yet about 80% of the gains from cooperation can be realized with a 4 party alliance consisting of the big producers. This smaller group has two advantages: coordination is easier and detection is easier. A smaller group means that the behavior of the 3 smaller countries is entirely predictable; thus, the detection problem is made much more manageable.

3. Have a clear target It is fine to agree in principle on production quotas, but there needs to be a clear target for what counts as good behavior and what triggers punishment. In the game, price offers an economically important and publicly observable coordination role.

Backing up a step, many of you stressed the need to "do your homework" before coming to the auction. This mostly meant doing a careful valuation analysis before bidding. While this is undoubtedly important, at least as critical is doing your homework in terms of figuring out a workable plan for cooperation. Effective leadership involves preparing a detailed roadmap for coordination and supporting this with careful economic arguments that can be shared across the parties seeking to cooperate. Too often this aspect--the outward thinking aspect--is neglected in determining valuations. This is true not just in OPEC but in M&A more generally.

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