MANAGEMENT INSIGHT - Rook to D7: Game Theory in the Pharma Industry

Chess is an allegory for business. Plot several steps ahead of your current move. Anticipate your opponent. Compensate for your weaknesses. Take inventory of your resources, and use them all for maximum advantage before going on the attack.

People believe chess is a test of intelligence. This may be true at the beginning stages, but not in advanced play. No matter how clever you are, you can’t win against an experienced player unless you, too, have studied the tactics. At a C or 1500 level – not an easy level to achieve – 90% of what players do is still just identifying common tactics to be able to avoid traps. Business is not much different.

Chess has a defined playing field and a set number of possible moves, allowing us to calculate its complexity The number of legal positions in chess is between 10^43 and 10^50, with a game-tree complexity of approximately 10^123. In business, the number of legal positions is infinite, rendering the complexity incalculable. Still, just as in chess, there are basic strategies that are frequently followed, and if you don’t recognize the moves and deploy them to your advantage, you will be quickly outmaneuvered, no matter how clever you are.

Len Fisher’s book, Rock, Paper, Scissors, is a lively study that illustrates many of the basic tactics in game theory; plays that are of infinite value both in business and in life. Developed in the 1940s, game theory looks at the decisions people make when confronted with competitive situations, especially when they have limited information about the other players’ choices.

Such games typically have a Nash equilibrium, which (roughly speaking) is the result when players behave selfishly. Many times, there are also cooperative strategies on the table that would make everyone better off, creating a social optimum.

Knowledge of these and other basic strategies of the game are essential reading in today’s business world. In the world of chess, you need to know a Caro-kann opening from a Sicilian opening so you can anticipate and react preemptively. In business, you should be aware of a couple of approaches to achieve cooperation in the face of temptations to cheat. Fisher brings us abreast of several basic and advanced tactics, including the Tragedy of the Commons; Free Rider; Chicken; Volunteer’s Dilemma; the Prisoner’s Dilemna; the Battle of the Sexes; and the Stag Hunt.

PATHEON & BANNER: A FRESH CHESS BOARD

The game was pretty much over in the soft-gel market before Patheon bought Banner. There were only two players in the market: Catalent, a company with a broad range of offerings producing a high-end product with an excellent reputation, and Banner, a onetrick pony producing only soft gels and not really considered a credible vendor. Catalent held a near monopoly.

Customers, predictably, didn’t like it. “Numerous existing Patheon customers have been specifically requesting soft-gel manufacturing alternatives to their current suppliers,” says Patheon President Geoff Glass to Outsourcing-pharma.com. Addin Patheon’s breadth of offerings to Banner’s patent-pending drug delivery platforms was like sweeping the pieces off the board and starting the game fresh. Assuming Patheon now offers a credible product of equal value to Catalent’s, there is now the potential for some serious competition.

At a glance, it might seem that Patheon should take market share. Not necessarily. Just having the right product in the right market isn’t enough. The outcome will depend on how Patheon plays the game. Soft-gel customers can also influence the outcome based on how they play the two major manufacturers against each other. This is the point at which business becomes more about game theory than about product offerings.

GAME THEORY & THE HOLLAND SWEETENER COMPANY (HSC)

To understand the game Patheon and Catalent are playing, it’s helpful to recall a classic case study in game theory. This is one that was impressed upon me not just by my MBA professors many years ago, but later when I spent more than 10 years working for DSM, the parent company that owned Holland Sweetener Company and primary problem owner in this Harvard Business Review case study on game theory.

HSC was a joint venture between DSM and a Japanese company. It was formed with only one purpose: to creat a competitor to NutraSweet (remember the little swirl on your Coke or Pepsi can?). NutraSweet was a brand name for aspartame, and a 100% monopoly owned by the Monsanto Corporation. It was a sweet market, enjoying 8% returns in 1986, and the market was projecting 75% growth in the following year.

The product HSC produced was essentially identical to NutraSweet. Shipping costs were so low as to be insignificant, so it didn’t really matter where it was produced. The only real basis for competition was price.

HSC was well positioned to withstand a price war. It had the financial strength behind it to take a beating, as did NutraSweet. But the fledgling company also brought with it the Tosoh patented process for manufacturing aspartame, which was less costly and more flexible. In addition, HSC had better knowledge of the European market, and access to raw material supply. Monsanto had good reason to take this new threat very seriously. For its own reckoning, the Monsanto plant had the capacity to produce 7000 tons, compared to HSC’s 500-ton plant. Monsanto had economies of scale.

Neither side would want a price war – a game that produces two losers before it produces a winner. A price war, following Fisher’s thinking, is just another form of a game of Chicken. How low can you go? The price can go so low that both sides end up subsidizing sales by borrowing from the larger company’s reserves, until finally one player is forced to exit the market. If the players take the game too far, it’s possible to bring both companies down.

This is the point at which game theory entered the equation. HSC had to put itself in the shoes of its competitor and anticipate what Monsanto would do to minimize the impact of HSC on its own bottom line. HSC determined that Monsanto would not choose a price war. The pie was big enough for both of them, and Monsanto would accept the inevitability of competition, rather than risk ruin for both.

That proved to be a fatal miscalculation, and it was made worse by the fact that HSC made no preparations whatsoever for what they perceived as the slim possibility that Monsanto would indeed launch a pric war. HSC was completely vulnerable when Monsanto began aggressively slashing prices. Monsanto, it turned out, had a safety net. With multi-year contracts locking up Coca cola and Pepsi as clients, Monsanto was guaranteed volume, and by extension, something of a profit cushion. HSC had no cushion whatsoever, so the losse came hard and fast. For years a bitter price war ensued, but HSC never filled its 500-ton plant enough to make even the slimmest profit. In 2008, HSC’s parent company finally closed the financial spigot, the plant closed, and 100 employees were laid off.

It didn’t have to play out that way. If HSC had at least recognized the possibility of a price war, it would have strengthened its opening position with what game theorists call a Pay-to-Play strategy. Before entering the market, HSC should have gone to some of the largest consumers of aspartame and offered them a price substantially lower than what they were currently paying Monsanto in exchange for guaranteed volume. By doing so, they would ensure that they had enough volume to pay salaries and costs and to stay in the game, before entering the market. If Monsanto found out about these deals, all the better. Just demonstrating this staying power might have been enough to dissuade Monsanto from beginning a price war in the first place.

THE PAY-TO-PLAY MANEUVER IN ACTION: THE RANBAXY TEVA DEAL

Here is an example of the Pay-to- Play Theory used effectively. Last year, Ranbaxy was confronted with a major quality complaint from the FDA. Having just secured a 180-day exclusivity period to produce the first generic competitor to Lipitor as it came off patent, this potentially mega-lucrative deal was suddenly threatened.

Ranbaxy chose to create a back-up plan. If the FDA halted production in their own plant, they would have another plant in the wings pre-approved and ready to produce for them. Ranbaxy turned to Teva.

This was undoubtedly a solid strategy on Ranbaxy’s part, but Teva is also clever. Teva might have sat meekly on the sidelines waiting and hoping that the understudy would be needed, but instead, it made a deal. Teva gave Ranbaxy its word that it would be Ranbaxy’s back-up, in return for promise of payment either way. If Ranbaxy didn’t need Teva, Teva would still receive a payment just for its willingness to be ready in the wings. Ranbaxy apparently considered this a worthwhile investment because it accepted the deal, and in the end, Teva collected the payment without ever having to produce a single tablet.

It’s risky to do business without some form of guarantees. Wherever possible, you should look for ways to be paid to play. If the market sees value in what you have to offer, there is usually someone who will be willing to pay for your involvement.

PAY TO PLAY: THE SOFT GEL MARKET

According to Patheon, soft-gel capsule customers are demanding competition in this market. That seems likely because Catalent has been operating in a near monopoly – Banner did not make a serious competitor to many buyers. Patheon is changing that by incorporating Banner’s soft-gels as part of Patheon’s broader array of offerings. But just being there as a viable competitor is not a guarantee of success.

What happens now depends on how Catalent and Patheon play the game. Much as in the HSC case, there is the potential for a price war here. Catalent customers could be waiting quietly for Patheon to offer up lower prices, so that they can take those back to Catalent and force Catalent to lower its prices. If they then stay with Catalent – playing it safe, arguably – Patheon could find itself in HSC’s situation. Without a basic level of business – without being paid to play – Patheon could be forced to exit the market. Then Catalent can crank the prices back up, and customers will be back in the same position they were before.

Similarly, if Catalent locks up the major customers with long-term multiyear contracts, Patheon may never gain a foothold.

As is often the case in business, both companies have a quality product to offer in a lucrative market that wants competition. But the outcome won’t necessarily be determined by the quality of the offering. It will be determined by the way the game is played.

Derek G. Hennecke is President and CEO of Xcelience, a CDMO in formulation development and clinical packaging located in Tampa, FL. Mr Hennecke launched Xcelience as a management buyout in 2007, and the company has more than doubled in size. Prior to starting Xcelience, Mr. Hennecke worked for DSM as a turnaround manager in the global drug development community, managing an anti-infectives plant in Egypt, technical and commercial operations in a JV in Mexico, and a biologics facility in Montreal. He developed the formulation and business strategy of several drug compound introductions such as clavulanic acid, erythromycin derivatives and Tiamulin. A Canadian, he covets the Florida sun, but can’t be kept away from the rink for long. He is an avid fan of the Tampa Bay Lightning.