BazermanMoore

The Competitive Escalation Paradigm 105
related decisions. In general, we should try to be cognizant of the fact that our decisions
will tend to be biased by our past actions, and that we have a natural individual tendency
to escalate commitment, particularly after receiving negative feedback.
THE COMPETITIVE ESCALATION PARADIGM
In the unilateral escalation paradigm we have just described, justifications for nonrational
escalation lie within the individual; we escalate because of our own previous commitments.
In the competitive escalation paradigm, additional competitive forces feed
the escalatory process. This section examines the process of escalation in competitive
situations.
Imagine that two companies, A and B, are the most important in a given industry.
Company C, an important third player, is their potential target: either a key supplier or
a key buyer. C is worth $1 billion as a stand-alone company and would be worth $1.2
billion if managed by A or B, as a result of the synergy in the possible combination of A
and C or of B and C. If A were to acquire C, B would be at a catastrophic disadvantage
and would lose $0.5 billion. It would be similarly destructive to A if B were to acquire
C; A would also lose $0.5 billion. Finally, if either A or B makes an offer on C, the other
company will learn of the offer. Question: As the head of Company A, what do you do?
A typical response of executives to whom we have posed this problem is to offer
$1.1 billion to Company C, which if accepted, would create a $100 million benefit to A
and C. However, this offer, once made, creates a problem for B: If B does not act, B
loses $0.5 billion. So, rather than suffering a $0.5 billion loss, B offers $1.2 billion to
break even. Now A has a problem: If A does not act, A loses $0.5 billion. So, A offers
$1.3 billion to limit its losses to $100 million, rather than suffering a $0.5 billion loss.
The problem is now B’s, and we can easily see the auction escalating to an amount
around $1.7 billion, where both A and B end up losing $0.5 billion in this competition.
Any party quitting below that amount would still suffer a $0.5 billion loss.
This story is consistent with the lack of profit obtained by buyers in the merger
mania of the 1980s—in the aggregate, the synergy that was obtained in acquisitions
went to the sellers. This story is also consistent with a classroom auction that we have
run many times. It works as follows. The instructor at the front of the classroom takes a
$20 bill out of his/her pocket and announces the following:
I am about to auction off this $20 bill. You are free to participate or just watch the bidding
of others. People will be invited to call out bids in multiples of $1 until no further bidding
occurs, at which point the highest bidder will pay the amount bid and win the $20. The
only feature that distinguishes this auction from traditional auctions is a rule that the
second-highest bidder must also pay the amount that he or she bid, although he or she will
obviously not win the $20. For example, if Bill bid $3 and Jane bid $4, and bidding
stopped, I would pay Jane $16 ($20 – $4) and Bill, the second-highest bidder, would pay
me $3.
Would you be willing to bid $2 to start the auction? (Make this decision before
reading further.)