Blockbuster filed for bankruptcy in 2010.
In 2013, Nokia had to sell its handset division to Microsoft at a fraction of its value.
In 2022, Twitter’s new leadership made a series of abrupt changes that eroded advertisers’ trust within weeks of acquisition.
In each of these cases, the leadership or decision-makers were genuinely smart and had extensive industry experience. But why did they all make the same kind of mistakes?
It’s not like they didn’t have enough data or were moving too slowly. Individually, their decisions were completely rational, but collectively, they were catastrophic. Why? The decision framework they were using was strategically wrong for the situation they were in.
We will use game theory to map these situations as precisely as possible. Once we recognize those patterns, we may see how predictable they are. Not in the sense that you can predict which company will fail next, but it enables you to identify the structural conditions responsible for failure if you ever find your organization in them.
The Pattern Recognition Failure
Pattern recognition is not rocket science. We just have to identify things repeating over and over again, whether it is numbers or behaviour. But our limitation is that pattern recognition works well in familiar domains. When we are placed in new environments or are faced with novel situations, pattern recognition is hardly possible because everything is new for us.
In new situations, we take shelter in strategies and decisions that have served us well in the past, even though we know these circumstances are completely different. But since we don’t know anything else, we resort to what we knew worked. And that’s where the game becomes dangerous.
Strategies of chess don’t work in Shogi. You are indeed making the best moves (game theory calls it optimal strategy), but in a completely wrong game.
So, for an observer, making the same old moves might look like a mistake, but for a player, it’s completely rational. Because they are trying to map the unknown with what they know. And that is called a framing problem in Game Theory.
The three most common framing errors in business strategy:
Error 1: Treating a repeated game as a one-shot game
Not treating others fairly. For example, squeezing your supplier, underpaying employees, cutting corners on quality of deliverables. Some players see these moves as a part of business. But they forget that these short-term gains bring about long-term consequences.
This is not just about playing unfairly. Failing to recognize the nature of competition or market trends can also lead to huge setbacks.
For example, most companies treat a single auction as an isolated, one-shot event, which is true. But they often ignore the broader market context where they are playing a repeated, long-term game with those same competitors across multiple auctions.
Error 2: Treating a changed game as an unchanged one
This is what we talked about earlier. When you fail to recognize the shift in the environment or game, your optimal strategy loses the power to bring benefits as before. The change can be anything from a new technology or a regulation to the entry of a new player who is rewriting the rules of the game.
You have to continuously evaluate the playing field even if you are ahead of others because who knows when the game changes behind your back. Never write off a single change as unimportant; look for its impact. That will tell you more about its significance.
Error 3: Misidentifying who the actual players are
Some companies fail to realize the hidden players influencing the game and its outcome, such as complementors, substitutes, and regulatory bodies, who actively shape the competitive environment more than anyone else.
The Patterns of Predictable Failure
After identifying the common errors, we will determine how those repeated errors transform into a pattern leading to bad decisions.
Pattern 1: The Innovator’s Dilemma
In his book Innovator’s Dilemma, Clayton Christensen explains how incumbents often lose to new market entrants despite making rational decisions. A successful company makes moves in the market for value extraction through techniques like optimizing margins, serving profitable customers, investing in sustainable innovations, and more.
Meanwhile, a disruptive entrant plays the game to get a foothold in the market by building capabilities, strong customer relationships, often waiting and even accepting losses in a market segment that the incumbent doesn’t value or focus on much.
The decision to ignore the low-end market seems reasonable for an incumbent. Similarly, the decision to serve that same low-end market is a purely rational move for an entrant. This way, both companies, though functioning in the same market, are playing totally different games. And an incumbent almost always discovers this too late.
So what’s the pattern here?
The incumbent not only fails to realize the impact of the innovation brought by the disruptive entrant, but they are too late to respond, by which time the entrant has earned a strong foothold in the market.
Now, the entrant has the capabilities, customer base, clear cost structure, but more importantly, a working business model which sustains them in the game for the long run.
This failure to recognize the pattern isn’t borne of an executive’s psychological error or a successful company’s ego. It is a structural issue. Because an incumbent plays a high-margin game, it doesn’t entertain an innovation until it reaches a certain threshold.
And innovations mostly happen gradually, away from an incumbent’s sight, quickly compounding into disruption. So, the response window is closed by the time innovation reaches that threshold.
Pattern 2: The Coordination Failure
With the rise of digital distribution in 2000, the music industry, more specifically major labels such as Sony and Universal, was in jeopardy. They failed to create a digital distribution infrastructure before Napster, and Apple forced them to.
This was a multi-player game with misaligned incentives and a coordination failure.
Every major label was trapped in the prisoner’s dilemma. To make their digital platform more valuable, they had to provide a comprehensive music library containing all major artists.
For example, if Sony were to build a platform, they would need to license their albums to rival platforms. This helps competitors and the label lose their leverage. So, none offered complete cooperation.
Instead of coming together to build a shared platform, they got divided into different camps, releasing their own platforms. Sony and Universal created PressPlay. Whereas Warner, EMI, and BMG collaborated to launch MusicNet.
Because neither side wanted to give unrestricted access to the other platform, both offered limited catalogs that consumers hated.
This coordination failure allowed Apple to step in with iTunes. It realized the potential and managed to convince the desperate labels to aggregate their catalogs under one roof, allowing it to dominate the digital distribution of music.
In a multi-player coordination failure pattern, the collective action would benefit everyone, but it is restricted by the desire for individual incentives. When incumbents fail to solve their coordination problem, it creates a vacuum in the market, and if any outsider is quick to realize the potential and act immediately, they can easily extract the value that everyone else failed to capture.
Pattern 3: The Escalation Trap
When the Euro Disney resort opened in 1993 outside Paris, it quickly fell into a crisis. Despite millions of visitors, profits fell short of projections. Visitors skipped premium spending, but the park continued charging premium prices, assuming the market would eventually adapt to their model.
Result? By 1994, Euro Disney was on the verge of bankruptcy. Why did this happen?
Game theory suggests Disney was caught between sunk costs and a high-stakes reputation game. The company invested approximately $4 billion in that park. So, they continued with their failing strategy because they already had so much money invested. That’s your sunk cost fallacy.
Game theory suggests another factor at play here. Admitting defeat in Paris Park would signal their weakness to partners, investors, and governments in every market where Disney was operating. So, this was also a reputation game for them, just like for every successful enterprise.
The rational move, if we consider it a local game, would be to change their strategy first, cut losses, and make a significant restructuring. However, Disney chose the global reputation game, maintaining confidence in their brand name, staying the course, and nearly lost both.
Whenever there is a conflict between a local operational game and a global reputation game, most companies always choose the global reputation game, even if it clearly seems to lose the local game.
Even if a rational analysis would tell you to exit as early as possible and cut your losses, the company would instead make more commitment to a losing strategy beyond the point of exit.
In the case of Euro Disney, they eventually brought in a new CEO, renegotiated their debt with French banks and restructured their pricing. So, the park survived and eventually became profitable.
This teaches us that you can successfully manage the reputation game with a transparent restructuring, but only if you do that before the situation becomes existential.
What to Do When You Recognise the Pattern You’re In?
Identifying the pattern is just the first step. The more difficult undertaking comes afterwards: correcting those patterns. Because the structural forces that created these patterns will resist in one form or another.
If You’re in an Innovator’s Dilemma
The basic advice for this problem is to create a separate unit to explore disruption. But that strategy fails at execution. What happens is that a separate unit is often starved of resources because your core business needs them. So, the separate unit is either integrated into core or is shut down if it is utilizing resources in an amount that is creating problems for the core.
When we look at it through GT, we get a better way to handle this: change the payoff structure for the people making resource allocation decisions.
The innovator dilemma arises or persists because the executives allocating the resources are evaluated on the performance of the existing business. But in reality, their individual payoff is misaligned with the organization’s long-term interest. So, getting a separate unit is not a structural fit. It would require building a separate measurement and incentive system.
To change the allocation game, it would be more effective to compensate senior leaders based on a combination of current business performance and the new business market’s position.
Amazon’s other businesses like AWS, Prime, and Alexa became a success because they were given distinct performance metrics decoupled from their core retail margins. Jeff Bezos evaluated new businesses on long-term free cash flow potential instead of current period profitability. The payoff structure for investment decisions is designed specifically to address the innovator’s dilemma.
If You’re in a Coordination Failure
For the coordination problem, where collective benefit takes a backseat against individual incentives, the solution is to either change the incentives or the coordination mechanism.
Changing the incentives
UPI from NPCI is a textbook example. In India, everyone needed a universal, interoperable digital payment rail, but no bank would build it. Because it would require them to bear all the infrastructure cost while their competing banks get a free ride.
To break this gridlock, India’s banking sector and central bank established the National Payments Corporation of India (NPCI) as a neutral, shared entity to build public infrastructure.
So, apart from their two initial options: build it and help competitors, and don’t build it and miss the opportunity, banks now have a third option. With a new payoff structure, participation in the shared infrastructure seemed more beneficial than non-participation to every bank.
Changing the coordination mechanism
When you can’t change the individual incentives, you need a coordinator with enough credibility, such as standard bodies like IEEE in the electronics industry, ISO in manufacturing, and SWIFT for finance messaging.
These standard bodies can solve coordination failures that individual market players can’t solve on their own. The role of the coordinator here is to offer common knowledge that allows a simultaneous move from a suboptimal to an optimal equilibrium.
It is important to remember that when an industry gets stuck in coordination failure, the solution often does not lie in product or service but in the coordinator. It is the entity that establishes standards, builds shared infrastructure, or creates mechanisms that allow the industry to move simultaneously.
If You’re in an Escalation Trap
The GT solution for this failure pattern seems counterintuitive: You don’t need more rigorous analysis of whether to continue or not, but an exit rule established before the commitment is made.
Escalation traps work through a combination of sunk costs, reputational costs and the incremental nature of commitment decisions. At every decision point, the marginal cost of continuing looks small relative to the total invested capital. So, the decision to exit never feels urgent unless the situation becomes critical.
However, having pre-committed exit rules changes things. You can make it in advance, considering the reputational stakes and sunk cost, allowing you to exit when losses are low. Once you reach a trigger point, the decision was already made, and the reputational narrative was already established in advance.
Amazon is precommitted to project metrics that trigger automatic reviews and potential discontinuation. When the Fire Phone flopped, Amazon didn’t enter a multi-year cycle of incremental fixes; it executed an automatic review and discontinued the product line.
On the contrary, Kodak defended its legacy film photography despite its early innovations in digital photography. Similarly, Nokia also made repeated investments in its smartphone platform long after clear signals of market rejection.
A pre-committed evaluation framework would have helped them make a clean pivot instead of an exit decision forced by a market collapse at greater cost.
What the Game Theory Framework Adds And What It Doesn’t
I can’t stress this enough: Game Theory, in this instance, is not about predicting which company will fail. But about identifying the structural conditions that would make the failure more likely. Let’s revisit those patterns:
- With an Innovator’s Dilemma, the incumbent plays a different game (hence making the best moves but under wrong conditions) against a disruptive entrant.
- With the prisoner’s dilemma, players from the same industry face coordination failure.
- When a company has invested its capital and reputation without a clear exit criteria, they face an escalation trap.
- Systemic misallocation happens when a game structure changes but strategy frameworks don’t.
The most important thing you need to prevent a failure is not the ability to predict outcomes (through data analyses or otherwise) but the ability to identify your structural patterns that drive bad decisions before your failure becomes irreversible.
A business team that can identify its patterns before the response window is closed can certainly improve its outcomes. But if the team doesn’t care about what others are doing in their market segment, they will be too late to respond.
Conclusion
As I said before, it’s not like the companies making these bad decisions have worse analysts or executives in place; they are probably among the best. The thing is: they are using the wrong decision-making framework for their situation; like playing the best chess move in Shogi, it just won’t work.
Innovator’s dilemma does not mean failure of intelligence, but a failure of identification. Coordination failure is not a failure of leadership, only a structural consequence of misaligned incentives. The escalation trap is not a failure of persistence or nerve in the face of challenges but a purely rational response to a reputation game that outweighs the local operational game.
However, identifying these patterns does not guarantee better outcomes; the right response does. But identifying if it’s a structural problem and not an execution failure would keep you from making more dangerous mistakes.
You can use a game theory-based decision-making framework for a proper assessment of the situation, players, dynamics, and information to make the best possible move.