Understanding Value Creation and Value Capture

Every business needs an innovative game plan when it comes to value creation versus value capture. So where do you begin? If you ask Dr Lourdes Sosa, Course Convenor on the Competitive Strategy and Innovation online certificate course from the London School of Economics and Political Science (LSE), it all starts with understanding whether cooperation or competition is the more profitable strategy.

Transcript

In strategy, the most fundamental choices an executive can face involve the trade-off between value creation and value capture, a tension that is present all around us in everyday trade – from historically disastrous negotiations to the design of current patent systems. In order to explore this fundamental trade-off I need to first introduce the concept of coopetition, best done through a game of cards.

Imagine a game of cards in which there are three participants. The first player, who we will call “The Customer”, simply likes to buy pairs of cards with one card black and one card red for which she’s willing to pay a £100. The second player, who we will call “Supplier 1”, owns 26 black cards and would like to trade them for as much money as possible. The third player is a group of 26 participants who have to play independently, thus not coordinating among themselves, who we will call “Suppliers 2A to 2Z”, each owning one red card and each willing to trade it for as much money as possible.

In the simplest form of the game, Supplier 1 approaches each member of Supplier 2. Each trading couple agrees to a 50/50 split as they need each other to equal extents, and 26 pairs are formed. As a result, the customer gets 26 pairs, the maximum possible, for a £2,600 payment. Supplier 1 gets half of that, or £1,300 and every individual from Supplier 2 gets £50 for a total of £1,300 between them. The value created was 26 pairs for The Customer to enjoy, equivalent to £2,600 of trade.

The concept of coopetition is best described as a principle to review, in competitive interactions, whether cooperation could make you better off, and in cooperative interactions, whether competition could make you better off. This is the principle that explains why rival firms create research consortia.

Getting back to the game of cards, Supplier 1 knows she’s in cooperation with Supplier 2. So, could competition make her better off? To be better off, Supplier 1 can start by attempting to collect more than 50/50 in each transaction. But even if she approaches Supplier 2A, threatening to walk away if the agreement is not 60/40, instead Supplier 2A knows that she can decline and wait. Supplier 1 will always have an incentive to recapitulate later on. Why would Supplier 1 trade only 25 cards and never come back to Supplier 2A for the 26th? Because Suppliers 2B to 2Z can also foresee these dynamics, the game continues at 50/50.

That is unless Supplier 1 burns one of her cards and lets Supplier 2 know right away – economists call this concept a credible commitment. Any action that convinces all of Suppliers 2 that one of them will really end up out of trade, alters the resolution of this game, in this case, in favour of Supplier 1. Supplier 1 can now better negotiate with Suppliers 2, as these latter compete among themselves. This means Supplier 1 can now get her 60/40. In this scenario, only 25 pairs will be created for The Customer, but at £60 per pair, Supplier 1 will collect a total of £1,500 – more than before.

This is the central concept of coopetition and the clearest interpretation of value creation and capture. When a black card was burnt, The Customer enjoyed less value created – 25 instead of 26 pairs of cards to be precise. But Supplier 1 enjoyed more value capture – £1,500 instead of £1,300 to be precise. Supplier 1’s strategy was indeed about making strategic choices.