Burning bridges is route to his Nobel prize

October 12, 2005|By JAY HANCOCK

A decade ago, Best Buy, a then-regional electronics chain based in Minneapolis, threw all the chips on the table.

As the underdog in a fight against Circuit City, Best Buy announced it would build stores in virtually every major U.S. market, including Baltimore-Washington, whatever the cost.

Best Buy borrowed hundreds of millions of dollars, overpaid for real estate, cut prices to the marrow and by early 1997 had seen its stock price fall by half.

Crazy? Not if you consider work by Thomas C. Schelling, the University of Maryland emeritus professor who was announced Monday as a co-recipient of the Nobel prize in economics.

Among many practical accomplishments in a long career, Schelling, now 84, demonstrated that competitors such as Best Buy who show a willingness to risk everything can often intimidate rivals into passivity or backing down.

Faced with an opponent that seemed immune to risk, Circuit City reacted cautiously, stopped cutting prices so aggressively and set out to manage what in retrospect can be seen as a slow decline. Today, Best Buy's stock is worth four times its 1995 level; Circuit City's stayed the same.

This demonstrates Schelling's principle of "pre-commitment," which suggests that entities can paradoxically improve their chances of success by limiting their options - by cutting off opportunities for retreat, limiting policy tools or demonstrating a willingness to do so.

There are several academic papers demonstrating the business advantages of Best Buy-style bridge-burning, "of how to pre-commit yourself, when investing, in order to intimidate an opponent and maybe drive them out of business," Schelling said in an interview.

The most famous example of pre-commitment, which Schelling helped make famous, was the Cold War doctrine of mutually assured destruction, in which both the United States and the Soviet Union promised that any nuclear attack by the other would prompt a major retaliation in kind.

Of course it produced a standoff in which six decades passed with no nuclear launches and the sides had to compete in economics, not war, which favored the good guys.

"Game theory," they call it at universities. Game theory research won Nobels in 1994 for three scholars including John F. Nash Jr., subject of the movie A Beautiful Mind. But the name simultaneously obscures and trivializes the work. It's not about Monopoly or poker, unless life itself is a big game and the penalties for losing are defeat, poverty or death.

Game theory is nothing more than the formal recognition that society is a stew of competing interests - from homeowners and shoppers to nations and governments - and that a change in behavior by one entity can alter the playing field and potentially the competitive behavior of others.

This is a crucial insight. Traditional economic models often assume that people's interests and motivations remain unchanged over time. Of course they don't. Last year's economics Nobel, which went to Finn E. Kydland and Edward C. Prescott, also rewarded research that accounted for changing conditions.

As a branch of "behavioral economics," which combines psychology with economists' traditional formulas and spreadsheets, game theory supplies insights for the pursuit of politics, love, investing and, as noted, business and war. Unlike that of his co-laureate, American-Israeli Robert J. Aumann, Schelling's work was notably sparse in mathematics. He preferred clear prose and self-evident or easily supported propositions to a mathematical straitjacket.

I posed several current-affairs problems to Schelling and asked him analyze them through a game-theory lens. He declined to tackle the most obvious, Iraq, saying the situation is too complex to dissect in a couple minutes on the phone. (He'll NEVER get on Good Morning America now.) What about the Bush administration's rejection of the U.S.-Soviet Anti-Ballistic Missile Treaty and its pursuit of a missile defense?

Schelling cast doubt on missile defense as a worthwhile investment. Given their motivations and resources, emerging nuclear adversaries such as North Korea or Iran are extremely unlikely to deliver a bomb via missile, he said. Their rockets are unreliable, and a launched missile could be easily tracked and invite retaliation.

"If North Korea for example should get nuclear weapons, I think they would put them on a boat and sneak them into San Francisco or Long Beach," Schelling said. "They wouldn't depend on firing weapons [via missiles] that are bound to be somewhat erratic and unreliable." He didn't advocate scrapping missile defense research, but he wouldn't spend billions to build the system, either.

What about Hurricane Katrina? Should we give people disincentives to live in dangerous flood plains?

It depends on the cost, he said. He faulted Washington for promising to make New Orleans as good as new and protected forever - which will take many billions - without conducting rigorous analysis.

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