Call it revenge of the nerds if you like, but many high-school chess club presidents are landing
the most coveted strategic-planning positions at major corporations. Chess players realize that 
good strategic decisions require you to take into account the likely moves and countermoves of 
other players. They study their competitors’ approaches to the game and identify the likely 
sequence of moves that will follow any particular move they make. By looking forward and 
reasoning backward, they drive the game toward a checkmate victory.

This ability to look forward and reason backward is enormously valuable to strategic-decision 
makers. When a company builds a new chemical plant or paper mill, its profitability will often 
turn on whether or not competitors add capacity as well. Similarly, the success of new marketing
or pricing strategies depends on whether competitors replicate them. In oligopoly markets, it 
is hard to identify a strategic decision that isn’t influenced by the retaliatory countermoves 
it sets off. The best business strategists must be skilled at predicting future rounds of 
competitive conduct.

Yet this is easier said than done. Uncertainty often surrounds competitive conduct, and many 
managers either expect the companies they compete against to engage in the kind of competitive 
behavior they see as normal or make some other educated guess. But such assumptions can be 
dangerous. Managers unwittingly set off value-destroying price wars, get buried when incumbents
retaliate in markets those managers have attempted to enter, and cannibalize their own core 
markets because they have either ignored or made the wrong guesses about the reactions of 
competitors.

The good news is that game theory provides a structured process that can help managers make 
better strategic decisions when faced with the uncertainty of competitive conduct. Game theory 
isn’t new; economists, mathematicians, and political scientists have been developing it for more
than 50 years. What is new is an increased emphasis on game theory as a practical tool that 
real-world managers can use for making strategic decisions. For example, most participants in 
the recent US personal communications services (PCS) spectrum auctions hired game theorists to 
develop their bidding strategies. What follows is a systematic game theory process that has been
applied successfully in more than 100 company situations in the past five years.

The rules of the game
A good game theorist gets inside the heads of other players to understand their economic 
incentives and likely behavior. To do this, you should focus on five key elements of competitive
intelligence.

Define the strategic issue
What decision are you trying to make: pricing, capacity, market entry? How is it related to 
other strategic decisions being made in the market? If you are trying to make a decision on 
capacity investment, for example, it is vital that you know whether others in the market are 
also considering entering or leaving it.

Determine the relevant players
Which players’ actions will have the greatest impact on the success of your strategy? A common 
mistake is to assume that all your strategic games are played against competitors and that there
is always a winner and a loser. Many of your strategic decisions turn on the actions of other 
players in the market—suppliers, distributors, providers of complementary goods—and "win-win" 
outcomes are attainable. For example, a computer hardware manufacturer attempting to stimulate 
demand for its product must focus on the economic incentives of software producers to provide 
products consistent with its operating system. A thorough understanding of these incentives 
allows the hardware producer to structure contracts, joint ventures, or alliances that make both
parties better off.

Identify each player’s strategic objectives
In real business games, players often base decisions, at least in the short run, on criteria 
such as market share or growth. Textbook game theory commonly assumes that the players seek 
rational, profit-maximizing objectives. However, in real business games players often base 
decisions, at least in the short run, on criteria such as market share or growth. It is extremely
important to get such criteria right. If you make the decision to enter a new market in the 
belief that the incumbent players are profit maximizers when they are really driven primarily 
by short-run market share objectives, you might suffer unexpected losses when the incumbents 
slash prices to maintain share.

Identify the potential actions for each player
For each player in the game, including yourself, develop a list of potential actions on the 
strategic issue. Generate this list from the perspective of the other players, not just your own.
What options might they be considering? How will they evaluate these options? Don’t assume that 
you and your competitors have the same set of strategic options. Competitive role-playing 
exercises involving external experts and your management team can help generate these lists.

Determine the likely structure of the game
Will decisions be made simultaneously, in isolation, or sequentially, over time? If sequentially,
who is likely to lead and to follow? Will this be a one-shot decision, or will it be repeated? 
Most business games are repeated, sequential games; pricing decisions, for example, are made 
over and over in sequence in most markets.

Game theory can help you play your current game better, but often its greatest value is to help 
players define new games. Third, and perhaps most important, while attempting to model the 
current industry, game managers invariably develop insights about how to change games to drive 
more favorable outcomes. Unlike board games such as chess, business games don’t have fixed rules,
players, and potential moves. Although game theory can help you play your current game better, 
its greatest value often comes from helping players define new games. In some cases, for example,
game theory predicts that current market conditions make price wars highly likely because 
customers switch easily between competitors. The current game-modeling exercise identifies the 
need to change the game by implementing customer loyalty programs, such as frequent-flyer 
discounts, that create value for customers and companies and decrease incentives for destructive
price competition.

Apply game theory the next time you need to make a strategic decision about which competitive 
interactions matter. Look forward and reason backward to generate insights about how to play 
your current business game more successfully. At the same time, make sure you leverage these 
insights to define better games to play. If you don’t change your game to gain advantage, one
of your competitors will, and there is not much value in being the best chess player when 
everyone else is playing checkers. 

Source: The McKinsey Quarterly, 2000 Strategy Anthology, http://www.mckinseyquarterly.com/
article_page.aspx?ar=1058&L2=21&L3=37 Authors: Hugh Courtney is a consultant in McKinsey’s 
Washington, DC, office. This article is adapted from one that appeared in World Economic 
Affairs, Autumn 1997.1