Business Journal 3

Cooperation

The Dos and Don’ts

Bruce Greenwald and Judd Khan

Successful cooperation is neither common nor easy. The rival firms have to find a way to work

in harmony to advance their joint interests, and they have to do it legally, to avoid drawing down

the wrath of the agencies charged with preventing and punishing restraint of trade. The episodes

presented in this chapter represent three potential outcomes of a potentially cooperative

arrangement.

In the first, Nintendo allowed its drive to dominate and its sense of in-vulnerability blind it to the

need for more jointly beneficial relationships with its suppliers and customers. As a result, they

were only too happy to see competitors encroach on Nintendo’s turf and cut it down to size. The

second example describes the successful cooperative arrangement established by the producers

of lead-based gasoline additives. They made the most of an industry condemned to a slow death

by environmental regulations. Finally, the two major auction houses, Sotheby’s and Christie’s,

decided to get together and end their practice of competing by lowering prices. Unfortunately for

them, the “getting together” took the form of overt and illegal collusion, which sent one of the

principals to prison and others into retirement. We suggest that they could have accomplished

most of their goals without such ruinous consequences.

HOW TO BREAK A VIRTUOUS CIRCLE: GAMES NINTENDO PLAYED

By the time Nintendo entered the market for home video games in the mid 1980s, the industry

had already experienced two booms and two devastating busts in its short life. In 1982, U.S.

consumers spent $3 billion on consoles and games; in 1985, the figure had dropped to $100

million. The situation was not very different in Japan until Nintendo and its little plumber Super

Mario brought life and income back into the industry. Starting in Japan in 1983, and then in the

United States in 1986, it sold its 8-bit game consoles into millions of homes. These consoles

were Nintendo’s equivalent of Gillette’s razors; it made its money selling the games. In Japan,

the average console owner bought twelve game cartridges; in the United States, he bought eight

of them. (We say “he” advisedly, since the typical gamer was a boy between eight and fourteen

years old.) By 1989, sales in North America recovered to $3 billion. And Nintendo had by far the

largest share of this market, around 95 percent in Japan, 90 percent in the United States. Between

consoles, games, royalties, and other sources, Nintendo’s own global sales exceed $4 billion in

1992.

Nintendo succeeded largely by improving the quality of the games available. In the late 1970s, it

had entered the arcade game sector with its first hit, Donkey Kong. Unlike the home console

market, the coin-operated arcade business did not collapse in the next decade; revenues of $5

billion in the mid 1980s indicated that the demand for a quality game experience was still strong.

The arcade machines were more powerful and much more costly than home consoles, and the

arcade owners had control over which games ran on the machines. A critical problem that had

plagued Atari and the other first-generation console makers was a flood of low-quality games,

many of them unlicensed and even counterfeit, that swamped the market. The console makers

derived no revenue from these intruders, and the poor quality of their games—at times they

simply didn’t work—undermined the whole industry.

Nintendo solved these problems. Its first hit for home console, Super Mario Brothers, was its

own creation, as were some of the other early successes. And it improved the technology of the

game console both to guard against unapproved, low-quality games and to make the systems

more powerful, though not more costly, in order to produce an experience more like that of

arcade games. Each game cartridge included two microchips, one to hold the game, the other a

coded security chip produced by Nintendo, without which the cartridge would not play on the

Nintendo console. The game chip also carried code common to all games that ran on the console.

By off-loading some of the functions from the console to the cartridge, Nintendo was able to

lower the console cost and make the hardware less expensive, even while it was raising the cost

of game software. The console sold for $100 at retail when it was introduced in Japan in 1983;

game cartridges sold for around $40.

The Nintendo approach succeeded from the very beginning. The company sold over 1 million

consoles in Japan in 1983, 2 million the following year, 3 million in 1985, and almost 4 million

in 1986. It had to modify the design of the console to enter the American market, making it look

more like a computer and less like a toy. But after some initial hesitation on the part of retailers,

the system took off and sales grew even more rapidly in the United States than in Japan. In 1989,

more than 9 million customers bought the system in the United States, and they supplemented

those purchases with more than 50 million game cartridges. By 1990, at least 70 percent of

American households with boys aged eight to fourteen owned a video game system. More than

90 percent of them were Nintendos.

THE NINTENDO SYSTEM

The management of Nintendo understood from early on that the availability of a variety of high-

quality games would be the driving force in the business. They also knew that they did not have

the creative resources within their company to turn out enough games to meet the demand. With

the costs of writing a single game at around $500,000, it was expensive and risky to try to

produce all the games themselves, since a game, like a movie, could fail to attract an audience.

They turned to licensing, allowing other companies to write games for the Nintendo system. The

original licenses in Japan went to six firms, all with direct or at least relevant experience in the

game world. Under the terms of the license, Nintendo was to receive a royalty of 20 percent on

the wholesale price of the games. Cartridges sold at wholesale for $30; each sale produced $6 for

Nintendo.

Though they had to spend a lot of money on game development and pay Nintendo a 20 percent

royalty, the original six licensees got very generous terms when measured against those imposed

by Nintendo on all subsequent game writers. The forty or so additional licensees that had signed

up by 1988 also paid the 20 percent royalty. In addition, they had to let Nintendo do all the

manufacturing, for which it charged them around $14 per unit. The initial order, for a minimum

of 10,000 units, needed to be paid for in advance. When Nintendo started a similar program with

outside developers in the United States, the initial order jumped to 30,000, and the cartridges

were delivered at Kobe, Japan, FOB (free on board, meaning the buyer owns the goods when

they leave the loading dock and must pay for the shipping), leaving it to the game writers to

import and distribute them in the United States. Nintendo itself contracted out the manufacturing

of the game cartridges to Ricoh, paying roughly $4 per cartridge. The $10 margin between the

$14 it charged and the money it paid Ricoh went to Nintendo. When the original six licenses

expired in 1989, they were reissued with the manufacturing clause included. Some of the

licensees grumbled, but they stayed with Nintendo. There was nowhere else to go.

Nintendo further controlled the game writers by limiting the number of titles they could produce

in any year to five. It tested them for quality and regulated the content; it would not license

games that it regarded as too violent or sexually suggestive. And as part of the license, the game

writers could not offer games for other video console systems for two years. They were locked in

to Nintendo. Given the overwhelming market share that Nintendo commanded, they virtually had

no choice. It was write for Nintendo with the prospects of producing a few profitable hits, or

write for the other consoles and live in a universe competing for the 10 percent of the market

Nintendo did not own.

Nintendo was equally dominant in its relationship with game retailers. When Nintendo had

initially tried to sell its game console into the U.S. market in 1985, toy retailers were

unresponsive. They had been burned with the precipitous decline of the earlier-generation game

machines, and may still have been trying to dispose of their unsold inventory of Atari VCS

systems. Nintendo decided to change the design of the machine and distribute it through

electronics retailers. Even then, it needed to sell them on consignment, charging stores only for

the units they actually sold. But the system quickly became popular, and Nintendo moved from

being a petitioner to a powerful vendor calling the shots.

Even retail giants like Wal-Mart, Kmart, and Toys “R” Us had to pay for their shipments

virtually upon receipt, rather than using the extended terms common in the toy industry. Wal-

Mart sold Nintendo systems exclusively, and all the retailers adhered to Nintendo’s suggested

retail pricing for systems and game cartridges. Nintendo insisted that its retailers establish

prominent Nintendo game centers in their stores, and they readily complied. Because Nintendo

actually shipped fewer cartridges than the retailers ordered, and fewer than the customers

wanted, they could reduce allocations to any of the merchants who would not play by Nintendo’s

rules.

Nintendo’s success and its treatment of retailers and game writers drew critics, including the

head of the House Subcommittee on Antitrust, Deregulations, and Privatization. In 1989, he

asked the Justice Department to investigate some of the company’s practices. Two years later,

Nintendo signed a consent decree with the Federal Trade Commission and some states’ attorneys

general agreeing to stop fixing retail prices. But its dominance among retailers and game writers

was largely unaffected. There were structural reasons that explained its continuing strength.

By the late 1980s, the shape of the video game industry had stabilized in the form shown in

figure 15.1. The game console producers were at the center of the industry. They designed,

distributed, and promoted the machines on which the games are played. They sometimes did the

manufacturing themselves, assembling them from purchased chips and other components, but

just as frequently, like Nintendo, they subcontracted out manufacturing. They produced some of

their own games, but these constituted a relatively small fraction of the games available.

FIGURE 15.1

Map of the video game industry, late 1980s

During its rise to dominance, Nintendo faced competition in this segment from Atari, Activision,

and Sega. Some early console producers like Coleco, Mattel, and Magnavox had disappeared by

then, but newcomers like Sony and Microsoft entered the industry. By the early 1990s, this

segment was dominated by Nintendo. Component and chip producers, who also often assemble

systems for the game console companies, included well-known electronics and chip companies,

as well as smaller and more obscure electronics manufacturers. This sector was highly

competitive, and the console companies were just one of many groups of customers, and a

relatively minor one. Games were designed and produced by a large number of creative firms,

including the console producers themselves. Hudson, Electronic Arts, Taino, Komani, Bandai,

Namco, and Taino were prominent names in this sector. Finally, both consoles and game

cartridges were distributed through toy stores like Toys “R” Us, mass merchants like Wal-Mart,

electronics stores like Circuit City, and other specialty retailers.

Because the manufacturing sector was highly competitive and only peripherally dependent on

home video games, the three key sectors were game writers, console producers, and retailers.

From the later 1980s through the early and mid 1990s, Nintendo stood out as the dominant

player. Looking at the industry from a cooperative perspective, the most efficient configuration

was to have a single system at the center of the market. Game writers would have to bear the

expense of producing only one version of each game, and they would have access to the

complete universe of potential customers. Retailers would need to stock titles for only one

system, and thus could offer more games with lower inventory expense than if they needed a

version for each competing console. Game players would have to learn to operate only one

system and would be able to play all available games on that one console.

Even the objection that a single dominant supplier would have no incentive to innovate and keep

up with rapidly changing technology would not apply. The fixed research and development costs

of bringing out new generations of technology would be lower with a single system supplier than

with multiple suppliers developing overlapping and duplicative technologies. Successive

generations of consoles with upgraded capacities could be introduced in an orderly sequence,

like the innovations for the Wintel platform for PCs, instead of in haphazard fashion that

rendered earlier generations of games obsolete before replacements were fully available. Finally,

profits for the entire industry could be maximized with a strategy of pricing the consoles to break

even and making all the profits on the sale of games.

If Nintendo had been willing to share the benefits of this organization with the game writers and

the retailers, there was no inherent reason why the strategy should not have survived several

generations of technology. On the other hand, if Nintendo persisted in trying to capture a

disproportionate share of industry profits, then its position would survive only so long as its

competitive advantages were sustainable.

WHICH COMPETITIVE ADVANTAGES?

From the time it entered the video game market with its own console system, Nintendo’s success

was sufficient to suggest that it did enjoy competitive advantages in the industry. It had an

overwhelming and stable share of the market throughout the period, controlling 95 percent of the

console business in Japan, 90 percent in the United States. The business was highly profitable.

From 1984 through 1992, Nintendo averaged over 23 percent return on equity. On these two

quantitative measures, Nintendo passes the incumbent competitive advantage test, at least in the

period before 1992. The stock market certainly priced Nintendo as if it owned a powerful

franchise. In 1991, its market capitalization of 2.4 trillion yen (over $16 billioin in 1991

exchange rate) was ten times the book value of its equity. It had a higher market value than Sony

and Nissan, firms considerably larger and more established. But if someone examined the

sources of these competitive advantages in 1991, it was not at all certain that they would be

sustained into the future.

Captive Customers?

Its large installed base of 8-bit video game consoles gave Nintendo some degree of customer

captivity, due to the switching costs a customer faced once he had bought the machine. No

Nintendo owner was going to buy a game cartridge (or CD-ROM, which was becoming an

alternative format) not compatible with his machine. But the strength of this customer advantage

was weakened by certain inherent features of the video game business.

The customer base turned over quickly. The fourteen-year-old boys became fifteen, reduced their

game-buying habits, and gave up their spot to younger kids turning eight or nine who did not

already own a game console and so were not as committed to Nintendo.

The price of the console, relative to the cost of a game, was low. With the games costing $40 or

more, a replacement console at $100 or $150 was no more expensive than a few games.

New technology in the form of faster chips able to process broader streams of data (16, 32, 64,

and 128 bits) was becoming available, and at prices not much more than Nintendo’s 8-bit

warhorse. Bigger and faster microprocessors meant more realistic games. At some point, the

quality differential between a fast new machine and a tired Nintendo would become large enough

so that both the new younger customers, getting their first consoles as presents, and their older

brothers, demanding to keep up with the youngsters, would make the switch, and all of

Nintendo’s arsenal of software would do it little good. Also, games get boring. The demand for

new games is like Pac-Man; it eats the value of the existing collection.

Better Technology?

Nintendo was clever in putting a security chip in each of the cartridges it produced, but the chip

itself was standard issue. There was nothing proprietary about its technology; it had no

meaningful patents. In the drive to keep the cost of its console down, it bought commodity parts

from suppliers like Ricoh. To stop a company that had found a way around its security chip from

selling unlicensed games, it pressured the gaming magazines not to carry ads from the intruder.

Nintendo was largely an assembler of standard parts, and it even contracted out much of the

assembly. Nintendo did not owe its profitability to superior technology.

Economies of Scale?

A potential licensee needed to spend around $500,000 in creating a game. But even with the

variable margin squeezed by Nintendo to $10 per copy, that fixed cost was absorbed by the first

50,000 copies sold, which represented only a tiny fraction of the total annual unit sales. With

annual video game cartridge sales of 50 million units, to reach the break-even point, a particular

game would have to capture only about one-tenth of 1 percent of the market. The design and

production of the game consoles also exhibited few economies of scale. Research and

development costs were relatively low. Manufacturing consisted of simple assembly operations,

not a process in which there are likely to be any identifiable scale economies. Between 1987 and

1992, Nintendo itself averaged only about ¥14 ($100) in fixed assets for every ¥100 in sales, and

this ratio did not decline significantly over time as Nintendo grew.

The Virtuous Circle

What Nintendo did have working in its favor was the virtuous circle of network externalities.

Once the Nintendo system had established a substantial installed base, more outside software

companies wanted to write games for it, which made the console more popular, meaning even

more games, and on and on. The virtuous circle extended to retailers as well as game writers.

Because retailers were reluctant to carry competing consoles and games, customers could find

Nintendo products much more easily than any alternatives. And Nintendo, a great marketing

organization, established displays in 10,000 outlets where customers could try out the system and

the games. Having dedicated real estate within a retail store is every manufacturer’s dream.

Retailers, on the other hand, are generally reluctant to cede control over their primary asset:

selling space. As a result, dedicated retail space is only made available to dominant

manufacturers. Controlling this space reinforces their dominance, and so on.

The extraordinary penetration of Nintendo products also provided the company with the scale

necessary to publish a magazine exclusively for Nintendo video game players to boost sales of

its games. The magazine accepted no advertising; it rated games, previewed new releases, and

offered tips on playing current games. It was priced to break even, and by 1990 it had a larger

circulation, at 6 million copies per month, than any other magazine in the United States

dedicated to children.

BREAKING THE CIRCLE

Despite all these benefits that reinforced its position, including the fact that the efficient

configuration for this industry mandated a single console supplier, Nintendo was still vulnerable.

Its virtuous circle rested on two advantages that turned out to be less solid than Nintendo

assumed. One was the enormous installed based of Nintendo’s console; the other was the

cooperative relationship between Nintendo, the game writers, and the retailers.

The first advantage would be wiped out by each new generation of technology. As the chips

advanced from 8- to 16-, 32-, 64-, 128-, and even 256-bit processors, the graphical quality and

power of the new machines would render the old systems and games obsolete. Nintendo’s

installed base of 8-bit machines would not be attractive to either the game writers or the retailers,

who sold games primarily for the new systems.

The second advantage, its relationships up- and downstream, might then tide Nintendo over until

it had built up a dominant installed base of new-generation systems, but only provided that the

writers and the stores felt they had mutually beneficial relationships with Nintendo. Game

writers would then reserve their best next-generation games for the introduction of Nintendo

systems, and stores would continue to provide Nintendo with unequaled store space. But if

Nintendo had bullied these constituencies and grabbed a disproportionate share of industry

profits, leaving the writers and retailers waiting for the opportunity to escape Nintendo’s grip,

then the opposite would happen. The best new-generation games would be retained for

Nintendo’s competitors, who would be welcomed by the retailers with shelf space rivaling

Nintendo’s.*

Nintendo did not play well with others. It did not share industry returns fairly. The terms it

imposed on game writers and distributors helped to make it rich, but they did not endear it to its

neighbors in the value chain. Nintendo treated the game writers particularly poorly. In the typical

game cartridge, there was roughly $26 of margin between the wholesale price of $30 and the

manufacturing cost of $4. Nintendo took $16, or 60 percent, for itself. The game writers, who

incurred all the costs and risks of development and distribution, received $10, or less than 40

percent.

Nintendo upset the game writers in other ways. It limited them to five new titles per year. This

restriction protected Nintendo from becoming too dependent on one software provider and

ensured that no game writer could become successful enough to consider creating its own

console system. But it frustrated the game writers, especially the most talented ones, and limited

their potential returns. There was also the censoring of content that limited violence and

sexuality. And Nintendo persistently shipped fewer console and game units than retailers ordered

during the crucial Christmas season. This imposed shortage may have enhanced the Nintendo

mystique, but it cut into the sales and profits of the game writers and retailers, who were also

alienated by Nintendo’s aggressive payment schedules and demands for in-store displays.

Sega brought out a 16-bit console in Japan in 1988 with better graphics and sound than the 8-bit

Nintendo standard. Still, Sega initially found it difficult to induce outside developers to produce

games for the system. Sega itself adapted some of the games it had created for the arcade market,

but sales remained slow. The company did not back off, however. It introduced the machine in

the United States in 1989, selling it for $190. Games retailed between $40 and $70. Sega targeted

these games at the content niches left uncovered by Nintendo’s censoring policy. Still, like

Nintendo in its early days, Sega had a difficult time selling the machines. Whereas Nintendo had

Wal-Mart and Toys “R” Us as its primary retailers, Sega had to rely on software stores like

Babbage’s.

But its fortunes changed in 1991, when a new executive decided to package both the console and

its popular game Sonic the Hedgehog for $150. That did the trick. The Sega machine took off,

and game writers rushed to supply product for it. Nintendo had delayed introducing its own 16-

bit system, not wanting to cut into its thriving 8-bit empire. It followed Sega into the 16-bit

market, but not in time to prevent the entrant from gaining enough scale so that it had no

problems securing games or distribution.

Between 1992 and 1994, the two companies battled for leadership, using all the weapons in a

marketer’s arsenal, including deep price cuts and heavy advertising. If it were a video game, one

newspaper suggested, it would be called “Marketing Kombat,” an allusion to the wildly popular

game Mortal Kombat. Each company claimed to be the market leader, but it didn’t matter who

had won the larger share. Nintendo was the clear loser. Hand-to-hand combat in the video game

trenches undermined the profitability it had enjoyed when it reigned supreme in the center of the

virtuous circle. Sony’s entrance with a 32-bit machine in 1995 just raised the competition to a

higher megahertz. In that year, there were eight or nine companies with 32-bit or better consoles

vying for a piece of the action.

Nintendo’s dominant position was undercut by its own decisions. It chose to milk its 8-bit

franchise rather than immediately respond to Sega in the 16-bit world. Also, its policy of keeping

shipments below demand inadvertently handed customers to Sega. But even before Sega’s Sonic

the Hedgehog showed up, Nintendo had prepared the ground for Sega and subsequent

competitors. Once Sega had established its credibility, the retailers and especially the game

writers rushed to its support. It was the game writers who really undermined Nintendo.

Conventional wisdom in the video game industry is that the distinctiveness of the product lies in

the software. To cite one particular ad, “It’s in the game.” By alienating the game writers,

Nintendo gave “the game” to Sega and Sony.

There is no certainty that a cooperative strategy would have prevented the software firms from

signing up to develop games for Sega and Sony. All we know for certain is as soon as Sega

showed a little traction with its 16-bit player, they rushed to supply games for its system. The

developers were delighted to have multiple console makers in the market, even though it cost

more to turn out games for different platforms. They were able to negotiate better deals with the

hardware companies. In fact, power had shifted from Nintendo to the developers. “In the game

industry,” according to a BusinessWeek story, “content rules. No matter how technologically

advanced a console may be, it’s doomed without enticing game titles.” Now Sega, Sony,

Nintendo, and ultimately Microsoft were the supplicants, offering the developers better terms on

the costs of producing a CD (PlayStation machines used CDs rather than game cartridges) and

reduced royalty charges. They also began to help with development expenses. Because of the

more complex graphics now demanded, development could cost up to $10 million per game,

twenty times the average when Nintendo’s 8-bit standard held sway.

Nintendo went from a company with a dominant position in an industry and a high return on

capital to one competitor among many with at best ordinary returns on investment, in large part

because it did not play well with others. It claimed so much of the industry profit for itself that

both developers and retailers were ready to support new consoler makers. To see how savvy

companies can manage to do well by working together, we look next at a grubbier industry with

nothing like the glamour or future of electronic games—the providers of lead-based additives for

gasoline.

LEAD INTO GOLD: GETTING ALONG IN THE GASOLINE ADDITIVE BUSINESS

Consider an industry with these characteristics:

 Its product is a commodity

 There is substantial overcapacity

 Demand is guaranteed to decline rapidly

 It gets bad press and bad marks from government agencies and public interest groups

Under these circumstances, it is difficult to believe that the businesses operating within this

industry would be able to make any profit and inconceivable that they would earn exceptional

returns.

The managers of companies producing the lead-based additives used to boost octane ratings of

gasoline (reduce knocking) were able to pull off this difficult feat because they knew how to pull

together. Even after the Federal Trade Commission took exception to some of their business

practices, they found ways to cooperate and share the wealth. They responded to shrinking

demand by reducing their own capacity. One by one the companies left the business altogether,

selling out to the remaining players or simply shutting down. By the time the last of them had

exited, in the late 1990s, they had had a twenty-year history of making money in a bad business.

In 1974 there were four U.S. companies in the lead-based additive industry: Ethyl, DuPont, PPG,

and Nalco. Together they produced around 1 billion pounds of these chemical compounds. The

Ethyl Corporation had been in the business since 1924, originally as a joint venture between

General Motors and Standard Oil of New Jersey. A patent protected it from competition until

1948, when DuPont entered the business to capture some of the market and the attractive returns

Ethyl was earning. (In fact, DuPont had done production for Ethyl until the expiration of the

patent allowed it to sell the additive for itself.) PPG, through its purchase of Houston Chemical

Company, and Nalco were encouraged and assisted in getting into the business by Mobil and

Amoco, respectively. These big refiners were major users of the additives, and they sought to

spur competition and reduce their costs by sponsoring additional firms in the additive business.

In every instance these hopes were disappointed. Ethyl managed to co-opt each successive

entrant, limit competition, and sustain industry profitability.

Prospects for the industry changed sharply in 1973, when the Environmental Protection Agency

issued regulations intended to implement parts of the Clean Air Act of 1970. The regulations

were intended to phase out the use of lead-based additives over time. They relied on two tools.

First, starting with model year 1975, all new cars sold in the United States had to be equipped

with catalytic converters designed to reduce harmful exhaust omissions from automobiles. The

converters could not operate properly with lead-based additives in the gasoline, so refiners had to

produce unleaded gas for all new cars. Second, the EPA tried to deal with lead directly by

reducing the amount refiners could put into their gasoline. Ethyl was able to delay the

implementation of the regulation until 1976, but after that the quantity of permissible lead per

gallon, and thus the total market for the additives, began a steady decline. The billion pounds of

additives sold in the mid 1970s was reduced to around 200 million pounds ten years later, and to

almost nothing by 1996. Part of the drop came as cars sold before 1975 grew old and left the

roads; part came from the regulations on grams of lead per gallon.

Although the medical case against lead in the air was disputed for a time, the hazardous nature of

the additive compounds was always clear. They were flammable and explosive, toxic in contact

with the body, and dangerous to breathe. Refineries tried to keep no more than a ten-day supply

on hand to minimize the dangers. The compounds required special equipment both for

transportation and for storage. Still, the companies were able to ship the liquid in common

carriers. The ability to use common carriers rather than company-owned and dedicated fleets fit

perfectly with the commodity nature of the cargo.

THE LEAD ADDITIVE INDUSTRY

The structure of the industry that produced and bought these compounds was uncomplicated. A

small number of chemical companies bought raw materials, especially lead, processed them into

two different additives, tetraethyl lead (TEL) and tetramethyl lead (TML), and sold them to

gasoline refiners. Nalco used a different process to make its TML, but in practice its additives

were interchangeable with the others. All the producing companies were diversified, especially

DuPont and PPG. Even Ethyl, the pioneer and the company with the largest market share,

derived only 17 percent of its sales from these additives. Their customers were basically

domestic and offshore gasoline refineries, principally those operated by large integrated oil

companies. After the EPA began to limit use in the United States, the producers tried to maintain

their sales by finding foreign customers. They did sell some compounds abroad, but because of

high shipping costs and the hazardous nature of the material, these sales were generally from

plants also located overseas. There were also non-U.S. companies in this market.

Raw materials accounted for most of the costs of production. All the producers needed to buy

lead. Ethyl and DuPont made most of the rest of their inputs; PPG and Nalco relied more on

outside suppliers. No doubt there were cost differences among the four companies, but not so

much as to encourage any of them to take advantage of a position as low-cost producer.

It is difficult to see any significant competitive advantage that distinguished one firm in the

business from another. Ever since the original Ethyl patent expired in the 1940s, none of them

had proprietary technology. Their customers, especially the largest of them, bought from more

than one additive producer. Contracts generally ran for one year. When they came up for

renewal, the refiners encouraged the producers to compete for their business in the only way that

made a difference—price.

No refiner tried to differentiate its own gasoline by claiming that its lead came from Ethyl or

DuPont. So although there were established relationships between sellers and customers, and

perhaps some switching costs if the formulations were different, there was nothing so powerful

in the nexus between producer and refiner to indicate customer captivity. A maverick additive

producer could have expanded its business at any time, simply by lowering its prices.

The organization of production into a small number of plants—never more than seven—to

supply the whole industry suggests that there may have been some economies of scale. But the

large plants did not drive out the small ones, indicating that scale economies were limited. And

without some customer captivity, economies of scale in themselves do not create a sustained

competitive advantage.

Barriers to entry are another story. An insurmountable barrier protected the four firms in the

business. The EPA’s regulatory announcement in 1973 posted an unmistakable Do Not Trespass

sign for any firms contemplating entering the lead-based additive industry. Even if some

company could have secured the necessary permits from local authorities—highly unlikely given

the concerns about atmospheric lead—who would want to build a plant to produce a chemical

scheduled to disappear? By putting the industry on a certain path to extinction, the EPA ensured

that the existing firms would have the business to themselves, to profit as best they could during

the slow path to disappearance.

COOPERATION AMONG FRIENDS

In seeking to encourage some price competition among the lead additive producers, the major oil

companies had always been disappointed. New entrants to the industry quickly went native.

They learned to play along with the incumbents and to frustrate their sponsors. Perhaps the

regional concentration of the industry had something to do with the ease of acclimation. Except

for one DuPont facility in New Jersey and another in California, all the plants were on the Gulf

Coast in Texas or Louisiana, within a three-hundred-mile radius of one another and near to the

refineries they supplied. The engineers running the plants came from similar backgrounds. In any

case, both before and after environmental regulations signaled the ultimate end of the industry,

the players had found ways of working together to keep in check what otherwise might have

been brutal competition.

Most of the methods they used were checks on themselves, to make it more difficult to give

customers discounts or otherwise to deviate from established prices:

 Uniform pricing. Prices were quoted to include both the cost of the chemicals and the

cost of delivery. By including transportation in the quoted price, the suppliers prevented

themselves from offering a hidden discount with a lower delivery charge.

 Advance notice of price changes. When one of the suppliers wanted to change—raise—

the list price of the additive, the contracts called for it to give its customers thirty days’

notice, during which time they could order more supply at the existing price. Until 1977,

the additive manufacturers issued press releases to announce these changes, but then

ceased on advice of counsel. The refiners tried to induce other suppliers not to follow the

leader in raising prices, but almost always to no avail. There were thirty price increases in

the five years starting in 1974, and all of them held. Ethyl and DuPont were the initiators,

with PPG and Nalco following suit. The solidarity continued even after the press releases

stopped. The thirty-day advance notice of price increases meant that any supplier wishing

to maintain the lower price had to signal that intention thirty days before the increases by

other firms went into effect. If it gave the signal, the other firms would simply rescind the

announced price increases and the deviant firm’s intransigence would yield no benefit,

other than to the customers.

 Most-favored-nation pricing. Applied not to import duties but to the actual prices charged

for the chemicals, this policy assured every customer that it was getting the best price

available. More to the point, it put the suppliers in a self-imposed straitjacket, preventing

them from offering any special discount to a particular customer on the grounds that they

would have to give the same break to everyone. Ethyl and DuPont put the clause in their

contracts, and Nalco followed suit on many of its own.

Rounding out these pricing tactics was another practice the four suppliers adopted: joint sourcing

and producing. Simply put, an order placed with one supplier might be delivered from another

supplier’s plant, depending on location, availability of chemicals, and other practical

considerations, like relative productivity. The four manufacturers maintained a settlement system

among themselves, netting out all the shipments made for one another and paying only the

balances. Capacity, production, and sales figures for 1977 reveal the joint sourcing program in

operation (table 15.1).

TABLE 15.1

Capacity, production, and sales of lead-based additives, 1977 (millions of pounds)

DuPont had the largest capacity but trailed Ethyl in production. The two had comparable sales

volume. Clearly Ethyl brewed more additive than it sold, supplying some of DuPont’s and also

PPG’s customers. Joint sourcing eliminated much of the cost differential among the suppliers,

who could all take advantage of Ethyl’s efficiency. Taking cost out of the equation removed

whatever incentive the low-cost producer might have to gain market share at the expense of the

other three firms and minimized overall industry costs. Market share of sales varied only slightly

from year to year. In 1974, Ethyl controlled 33.5 percent of the market; in 1977, the number had

inched up to 34.6 percent. Indeed, there was a remarkable consistency in share changes. A large

company with a share of the market below 35 percent tended to increase share, whereas a

comparable company with more than 35 percent of the market generally lost share. For the small

competitors Nalco and PPG, this focal share was 15 percent. It appears that none of the firms

labored to increase its share of the market permanently.

The stability of market share of sales coupled with joint sourcing led to an unusual rationality in

capacity management. Since high-cost plants tended to operate at low capacity under joint

sourcing, they were the plants most likely to be shuttered as overall demand declined. In 1980,

Ethyl closed its oldest plant in Houston. DuPont followed a year later, shutting its Antioch,

California, facility. PPG left the business entirely in 1982. Joint sourcing created an incentive

structure that both eliminated excess capacity and closed the least-efficient plants first. The net

result was a strategy to manage capacity in order to minimize overall industry costs.

ENTER THE FEDERAL TRADE COMMISSION

Eventually, the four additive companies must have been doing something wrong because they

came to the attention of the FTC for alleged anticompetitive practices. In 1979 the commission

charged that four of their marketing practices were in violation of Section 5 of the Federal Trade

Commission Act:

 The thirty-day advance notice of list price changes

 Issuing press releases about these changes

 Selling the product on a uniform delivered price basis

 Using most-favored-nation pricing clauses in contracts

Because of these practices, the FTC contended, the four producers were able to “reduce

uncertainty about competitors’ prices,” and thus reduce or even eliminate price competition in

the lead-based additive market. Even though the practices themselves were not unlawful, by

using them to maintain price uniformity and stability the producers were accused of breaking the

law. The complaint said nothing about the policy of joint sourcing.

Two years later an administrative law judge upheld most of the complaint. Price signaling was

out. Instead of pre-announcing a price change to the industry, now the producers had thirty days

after it had gone into effect to make the change public. The most-favored-nation clauses were

forbidden, on the grounds they “discourage discounting and promote price uniformity.” The

judge said nothing about the Robinson-Patman Act, which prohibits a seller from price

discrimination among buyers. The judge found that the four producers constituted an

“oligopoly,” and as such, were proscribed from practices that were not in themselves illegal.

It took two additional years, until 1983, for the FTC itself to reaffirm most of the judge’s ruling.

Even though there was no collusion to fix prices, the commission wrote, the companies had

restrained competition. Ethyl and DuPont were ordered to stop:

 Announcing price changes before a time agreed upon between the company and the

purchaser

 Offering a single price to include delivery regardless of destination

 Guaranteeing customers that they would receive the lowest price available to any

customer

The commission did not uphold the prohibition on press conferences announcing price changes.

It excluded Nalco from the ruling because Nalco was an acknowledged price follower. By 1983,

PPG was no longer in the industry.

At the time of the ruling, the companies had already stopped announcing price changes

beforehand. They were able to replace a single price (uniform delivered pricing) with FOB

pricing (in which the buyer owns the goods when they leave the loading dock and pays directly

for shipping). Under either approach, the producers could not hide discounts by subsidizing

shipping costs. As to most-favored-nation pricing clauses, they might be removed from contracts

but maintained in practice. What customer, after all, did not want assurance that nobody else was

getting a better price?

Even when barred from using some of the specific tactics the additive makers had employed to

curb their own competitive juices, they continued to be masters of the prisoner’s dilemma game.

By the time the FTC had issued its ruling, they had had years of experience in effective

cooperation. So next to nothing changed as a consequence of the FTC’s intervention. The

industry continued its mandated decline and the producers continued to earn money even as they

sold less of the additives. In 1981, Ethyl’s additive business accounted for 17 percent of its sales

and 33 percent of its profits. Since the capital employed had no substantial liquidation value, the

return on capital was extraordinary.

EXIT THE PRODUCERS

If the Federal Trade Commission’s ruling had no discernible effect on the effectiveness of

cooperation among the lead additive producers, environmental regulations both within the United

States and abroad continued to reduce demand. Suppliers responded by closing plants, investing

the cash from lead-based additives into other products, and remaining focused on working for

mutual benefits. Nalco left the business, but Ethyl and DuPont continued production, Ethyl at a

plant in Ontario, Canada, DuPont in New Jersey. The other major international player was

Associated Octel, a company based in England but with Great Lakes Chemical, headquartered in

Indiana, as the majority owner. Until July 1994, DuPont supplied Ethyl with much of its product.

After DuPont closed its operations, Ethyl turned to Octel, signing an agreement in 1996 which

guaranteed Ethyl a dedicated portion of Octel’s production to sell through Ethyl’s distribution

channels. Ethyl then ceased production at its Ontario plant. The two companies proclaimed that

they would continue to compete with one another in the sale and marketing of lead antiknock

compounds.

Octel remained in the business for one reason: it was highly profitable. In 1994, Octel earned

$240 million of operating profit on sales of $520 million, a margin of almost 47 percent. All the

rest of Great Lakes Chemicals earned $162 million on revenues of $1,480 million, a margin of

11 percent. Great Lakes used its profits from lead-based additives to make acquisitions,

preparing for the day when the lead business would be entirely gone.

Ethyl displayed a similar disparity between earnings in lead-based additives and everything else,

even though it was largely a reseller of chemicals made elsewhere. Between 1994 and 1996, the

additives accounted for 23 percent of the company’s total sales and 63 percent of its profits. In

1998, after its additive revenues had declined to $117 million, it still made $51 million in

operating profits, a 44 percent return. The rest of the company had operating margins of 11

percent.

How energetically Ethyl and Octel competed for the small business remaining was revealed in

1998 when the FTC reentered the scene, charging that the arrangement the companies had

reached violated antitrust laws. Octel and Ethyl settled with the commission by agreeing to

change some features of the original contract. Under the new arrangement, Ethyl could buy more

than a fixed portion of Octel’s output and Octel would have to sell Ethyl all that Ethyl wanted to

serve its current and new customers in the United States. Ostensibly this would increase

competition between them, as would the other changes. The amount Ethyl was charged would no

longer be tied to Octel’s retail price. The companies would no longer disclose their prices to one

another. The companies agreed to notify the commission in advance of any acquisition of assets

used in the distribution of the compounds within the United States or manufacture anywhere in

the world. Finally, there would also be prior notification of any proposed agreements with other

competitors to sell them lead-based antiknock additives.

If it intended to protect American consumers, the FTC might have better looked elsewhere. Lead

additives had virtually disappeared from the U.S. market, and they were vanishing elsewhere in

the world as well. And no provisions in this ruling would do much to guarantee vigorous

competition. Neither Ethyl nor Octel was going to cut prices to secure a somewhat larger share

of a dying but still lucrative business. Octel, with the world as its market, continued to enjoy high

margins on sales (table15.2). After a tough year in 2000, its operating income recovered even as

its revenue declined. As Ethyl and Nalco before it, Octel used its cash flow from TEL (one of the

lead-based additives) to expand its specialty chemicals business. Like them, its returns from

specialty chemicals did not come close to what it was making in the lead additive business.

Octel will be the last to leave. But like all the other producers that departed before it, it will make

a graceful exit, at least as measured by profitability. By cooperating with one another even while

complying with antitrust laws, these companies experienced a long history of turning lead into

gold.

TABLE 15.2

Octel Corporation sales and operating income by segment, 2000–2002 ($ million)

KEEP YOUR DISTANCE: SOTHEBY’S AND CHRISTIE’S TURN COOPERATION INTO A

GENUINE PRISONER’S DILEMMA

For all their heritage, prestige, and cachet, Sotheby’s and Christie’s, the two leading auction

houses, were mediocre businesses. By 1990 they dominated the auction markets for fine art and

other expensive goods in Britain and the United States. They had steadily encroached on the

business of the art dealers by selling directly to collectors. Still, the volatility of the market for

expensive paintings and the other luxury items that went under their hammers left the two houses

vulnerable to the pain that a business with high fixed costs feels when revenue shrinks. In 1974,

in the aftermath of the oil embargo and recession, the two houses both imposed a charge on

buyers—the buyer’s premium—where previously it was only the sellers who had paid. The

auctioneers were probably trying to help recycle some of the rapidly growing wealth in the hands

of oil sheikhs from the Persian Gulf, who were now in the market for trophy paintings.

The buyer’s premium gave Sotheby’s and Christie’s a new source of revenue and may have

made it easier for them to compete with one another by lowering the commission they charged to

the sellers. And lower it they did. The tipsy art market of the late 1980s sobered up starting in

1990. Japanese buyers for top pictures stopped bidding—even stopped paying for works they had

supposedly bought—the U.S. economy slowed, and the Gulf War made customers wary. The

auction houses saw their business decline and turned to the oldest marketing ploy available: they

cut prices.

To induce sellers to put their items up for auction, and to try to attract business from one another,

Sotheby’s and Christie’s lowered their seller’s commission, sometimes to zero. They also offered

inexpensive advance loans on items to be auctioned during the next round of sales. They started

to print elaborate catalogs, often as a vanity inducement to the sellers. They gave lavish parties.

They even donated money to their sellers’ favorite charities. None of these practices brought

business back to where it had been in 1989, and they certainly did nothing to improve the

earnings of the houses (figure 15.2).

When the going gets tough, the toffs get together. In 1992, Sotheby’s changed the buyer’s

commission from a flat 10 percent of the sale to a sliding amount that was intended to bring in

more revenue. Seven weeks later Christie’s followed suit. The timing is interesting. By accounts

offered to the courts, the first actual meetings between the heads of the two houses, A. Alfred

Taubman of Sotheby’s and Sir Anthony Tennant of Christie’s, did not take place until 1993.

Taubman, the shopping mall magnate who had served as a white knight for Sotheby’s in 1983,

buying a controlling interest to keep it out of the hands of Marshall Cogan and Steven Swid, flew

to London to meet Sir A., as he was identified in Taubman’s records. According to the testimony

of their respective seconds, Diana D. (Dede) Brooks of Sotheby’s and Christopher Davidge of

Christie’s, Taubman and Tennant directed Davidge and Brooks to work out details of an

agreement under which the firms would not undercut one another on the commission rate offered

to sellers.

FIGURE 15.2

Sotheby’s revenue and operating income, 1987–2002 ($million)

In 1995, Christie’s announced that it was changing its seller’s fee from a flat 10 percent to a

sliding scale, ranging from 2 percent to 20 percent depending on the size of the sale. Over time,

the arrangement came to include a “no poaching” clause on key staff members and an accord not

to subsidize the sellers by offering below market interest rates on loan advances. The companies

also shared their “grandfathered” lists with one another, clients to whom they charged reduced or

even zero fees. Neither was supposed to pursue names on the other’s list, nor to offer these same

advantageous terms to people not on the lists. According to Brooks, Taubman wanted the houses

to collude on the estimates they provided sellers as to the likely value of their art at auction, but

she told him that those decisions were made by the respective professional staffs of the two

auction firms, who could not be controlled.

Rumors could not be controlled either. By 1997, it was widely known that the Justice

Department was investigating the auction houses for actions that violated antitrust laws. Perhaps

Justice had been tipped off by customers who discovered, sometime in the mid 1990s, that the

firms would no longer offer lower commission rates and wondered how such solidarity might

have been maintained in the absence of collusion. Just before the end of 1999, Christopher

Davidge cut a deal with the government. In exchange for no prison time for himself and other

members of Christie’s, he offered documents to prove the illegal behavior of Taubman, Tennant,

and their accomplices.

In 2000, the Justice Department pressured Diana Brooks to give up her former boss, Alfred

Taubman, in exchange for a stay-out-of-jail card. She did her part, pled guilty, and in the end,

Taubman was the only person to serve time. Sentenced to a one-year term in 2001, he was

released from prison after serving nine months. Each auction house paid a civil fine of $256

million, equal to around four years of Sotheby’s average pretax profits in the years 1995–98. Sir

Anthony Tennant always maintained his innocence, but just to make sure, he stayed in England

where he was safe from extradition on an antitrust violation.

The truly striking aspect of this story is how ineffective Christie’s and Sotheby’s were at

cooperating to sustain profitability, despite their illegal agreements. Profit margins at Sotheby’s

did grow between 1992 and 1996, as the art market recovered from its collapse in the early

1990s. After 1996, however, even as the art market improved, margins remained static. By 1998,

with revenues at or near their pre-collusion 1989 peak, operating earnings at Sotheby’s were only

half their 1989 level. And with only a slight decline in 1999 sales, operating profits at Sotheby’s

fell by almost 50 percent.

Davidge, his Christie’s colleagues, and Diana Brooks may not have known how to play the

cooperation game without violating antitrust laws, but they did know how to play the prisoner’s

dilemma game, at least in the first round. The New York Observer commented about the

prosecution, “They needed Mr. Davidge’s notes and testimony to win conditional amnesty from

the U.S. government, under a controversial program in which the crook who squeals first in such

a conspiracy gets off scot-free.” Though scot-free may not always be part of the deal, the crook

who squeals first always does better; otherwise, why would he or she squeal? The more

interesting question is what alternatives the two auction houses had to this illegal collusion as a

way of ending a painful war over price and perks.

Christie’s and Sotheby’s, which together shared some 90–95 percent of the high-end auction

market, should have been able to benefit from economies of scale and significant customer

captivity. Smaller and newer auction houses had made no inroads into their market share for

many years. Also, at least until they entered their period of intense competition, both

organizations were highly profitable. The key to continued success was restraint on competition,

which required primarily that they stay out of each other’s way. Geographically, it was not really

possible for two firms like these to divvy up territory. Each had major establishments in London

and New York, as befits their British ancestry and the strength of the market in the United States.

They also had satellite offices, and in some cases selling rooms, in major cities around the world.

But these locations were more for acquiring material than for auctioning it. For all expensive

items, buyers come to the auction in the most cosmopolitan locations. So Sotheby’s and

Christie’s both needed a presence in New York and London. In fact, they benefited from running

their auctions almost simultaneously, because more buyers were enticed to make the trip to town.

With geography an unwieldy knife with which to slice the pie, field specialization—product

market niches—remained the obvious choice by which to divide the business. Instead of selling

everything from Cycladic figures and ancient Sumerian pottery to paintings by Roy Lichtenstein

and Keith Haring, each house could have concentrated on particular periods and types of art.

They could also have selected specialties from the broad range of other objects offered for sale,

like antique Persian carpets, jewelry, and clocks and barometric measuring devices from the age

of Louis XIV.

The auction houses handled such a variety of goods that, in theory at least, staking out a set of

nonconflicting claims to territory should have been fairly simple. Each field required overhead to

support it, particularly the experts who validate claims about authenticity, research provenance,

and estimate a value for the item. If Sotheby’s had become the place to go for eighteenth-century

French paintings and decorative arts, and Christie’s had emerged as the dominant firm for color

field abstraction, then sellers would have had to choose an auction house on the basis of what

they were trying to sell. A further advantage of such specialization would have been a significant

reduction in overall overhead costs, since substantial duplication of effort would have been

eliminated.

There were two problems that would have made this type of division more difficult to

accomplish in practice than on paper. First, estate sales may encompass a variety of works that

don’t fit neatly into any single auction house’s specialization. Second, while Dutch master

paintings from the seventeenth century may bring more at auction than Postimpressionist works,

there are many fewer of them outside of museums. So a fair division of the playing field needed

to focus on the value to the auction house of a piece of the turf, not its attractiveness on any other

basis. Despite these difficulties, it may have been possible for the firms to work out an informal

and tacit arrangement without colluding directly.

In 1992, before the first reported meetings of Taubman and Tennant, Sotheby’s announced an

increase in fees charged to buyers, and Christie’s came along after a decorous delay of seven

weeks. Could Sotheby’s have also announced that it was deemphasizing its Egyptian and ancient

Middle Eastern departments, and concentrating instead on Greek and Roman antiquities and the

period to AD 1200 in Europe? Christie’s might have announced, some time later, that it was

going strengthen its Egyptian department and also its expertise in the early Renaissance. And,

over time and more subtly than we are describing here, the two might have divided up the map of

the fine art and object markets like the European imperialists carved up Africa in the nineteenth

century, hopefully to better effect. The estate sale issue would have been handled naturally,

leaving it up to the executors to decide among the auction houses on the basis of their respective

strengths. And nothing says that the estate property could not have been sold in a series of

auctions.

The contrast between the histories of Nintendo and the auction houses, on the one hand, and the

lead-based gasoline additive industry on the other clearly points up the benefits of effective

cooperation among firms. Just as clearly, it underscores the perils of inexpert cooperation that

crosses the legality line. A well-formulated strategy will not immediately or solely look to

salvation through cooperation. But the story of the lead-based additive industry demonstrates

how useful a cooperative perspective can be under the right conditions. The optimum situation is

an industry where several firms coexist within well-established barriers.