Winning the Hardware Software Game Winning the Hardware-Software Game - 2nd Edition

Using Game Theory to Optimize the Pace of New Technology Adoption
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Merriam-Webster defines membership as “the state of belonging to or being a part of a group or an organization.”

Being a (voluntary) member of a group generally confers both benefits and costs upon group members. The benefits and costs of group membership change over time, (i) as the environment – political, economic, social – changes, and (ii) as the composition of and dynamics between members of the group change. And as the benefits and costs change, existing members may be led to exit the group, while new members may be incentivized to join.

This analysis examines:

  • The benefits and costs of being a member of a group,
  • The different types of groups, and
  • Group dynamics as the environment and group membership change.

Figure 1


Types of Goods

Before discussing the different types of groups, I first provide definitions of different types of economic goods: private goods, common-pool resources, club goods, and public goods. We will see later that group membership and group dynamics can often be tied to issues surrounding members’ access to these different types of economic goods. As such, it’s important to first have an understanding of what the different types of goods are.

Economic goods may be classified into one of four different groups, depending on whether or not they are (i) excludable and/or (ii) rivalrous. Figure 2 illustrates the matrix of classifications, while Wikipedia provides definitions below.

Figure 2

 2 goods types


In economics, a good or service is called excludable if it is possible to prevent people (consumers) who have not paid for it from having access to it. By comparison, a good or service is non-excludable if non-paying consumers cannot be prevented from accessing it.


In economics, rivalry is a characteristic of a good... A rival (subtractable) good is a good whose consumption by one consumer prevents simultaneous consumption by other consumers. Put differently, a good is considered non-rival (non-subtractable) if, for any level of production, the cost of providing it to a marginal (additional) individual is zero.

Private Goods

A private good is defined in economics as "an item that yields positive benefits to people" that is excludable, i.e. its owners can exercise private property rights, preventing those who have not paid for it from using the good or consuming its benefits; and rivalrous, i.e. consumption by one necessarily prevents that of another.

Common-Pool Resources

In economics, a common-pool resource (CPR), also called a common property resource, is a type of good consisting of a natural or human-made resource system (e.g. an irrigation system or fishing grounds), whose size or characteristics makes it costly, but not impossible, to exclude potential beneficiaries from obtaining benefits from its use. Unlike pure public goods, common pool resources face problems of congestion or overuse, because they are subtractable.

Public Goods

In economics, a public good is a good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.

Club Goods

Club goods (also artificially scarce goods) are a type of good in economics, sometimes classified as a subtype of public goods that are excludable but non-rivalrous, at least until reaching a point where congestion occurs.

More on the Economic Theory of Clubs:

As developed in a seminal paper by James Buchanan (1965), the economic theory of clubs applies to goods having three key characteristics:

• Club goods are excludable. Individuals who do not contribute to financing the club can be prevented, at relatively low cost, from gaining access to the benefits of club membership.

Club goods are congestible. Although consumption is not entirely rivalrous (there is not, as in the case of a private good, a one-to-one relationship between the amount consumed by one person and the amount available for consumption by others), each member of the club imposes a negative externality on his fellows. That negative externality materializes in the form of crowding, which degrades the quality of the benefits consumed by all.

Club goods are divisible. Once a club’s membership has reached its optimal size, individuals who want to join but have been excluded can form a new club to produce and consume the same good. Clubs can in principle be cloned as the demand for them warrants.

The foregoing assumptions restrict the domain of the theory of club goods to what are commonly called ‘impure’ public goods. A ‘pure’ public good, by contrast, is neither excludable nor congestible. The optimal club size in that case has no upper bound.

Benefits and Costs of Group Membership

Figure 3 summarizes the general benefits and costs associated with joining a group. I discuss each of the specific categories of benefits and costs as they apply to the UK’s decision as to whether to Remain in or Leave the EU.

Figure 3

3 benefits costs 

Centralization of Authority

Being a member of the EU enables the UK to benefit from centralization of regulations across member countries. Rather than having to negotiate and abide by separate sets of laws or agreements – such as health and safety standards, tax and trade laws, currency exchanges, customs and immigration, etc. – for each of the member countries, the UK is able to abide by the uniform sets of law and agreements applicable across all EU member countries.

A cost of centralized authority is the loss of independence to make one’s own decisions. For example, as a member of the EU, the UK must abide by the common laws and agreements established by and for the EU, even if it thinks certain laws are not strict enough or if it thinks others are too strict. As an independent entity (e.g., after the Brexit), the UK is now able to establish it’s own laws. One of the hot-button issues surrounding the UK’s decision to Leave or Remain was the higher than desired immigration levels forced upon it by the EU. After the Brexit, UK is now able to limit immigration to levels that the UK feels are appropriate (see, for example, Kim Hjelmgaard and Gregg Zoroya, “Exploding UK immigration helped drive 'Brexit' vote.”)

Public Goods

The ability to gain access to more or better public and/or club goods is often a driving force for joining a group. Examples of public goods that attract new members to the group include

  • Access to military defense against enemies or attackers;
  • Access to resources, such as natural resources, medical care, low-priced loans; and
  • Access to infrastructure, such as a culture, a legal system, an educational system, or a currency system.

Membership in a group can generate costs to an entity with respect to access to public goods, in the form of free-riding or congestion by other members. A classic example of free-riding is new immigration into a region so as to take advantage of the region’s welfare benefits.

Transaction Costs

The ability to minimize transaction costs and/or realize economies of scale or scope is another important impetus for joining a group. One of the major benefits to EU members is the ability for people and goods to freely move across the borders of different countries within the EU. Another significant benefit from membership is lower-cost access to larger and more diverse markets, which enables providers to benefit from economies of scale and scope in the production of goods and services.


The centralization of authority and control often leads to the homogenization of differences across group members. This can be a benefit to the extent that homogenization enables efficiencies, such as the elimination of border controls, or the use of a single currency or language. Homogenization can also entail costs to group members, such as the loss of distinction or uniqueness in culture or methods.


Members of a group often benefit by receiving subsidies from other members of the group. On the other hand, though, members of a group are generally required to pay taxes to support the centralized administration, and perhaps also to support other group members financially (e.g., through subsidies or low-cost loans).


Good students exhibit positive externalities in that other students are able to learn from them. “Powerful” people exhibit positive externalities in that they can provide others with access to resources or opportunities. People with particular cultures or ethics exhibit externalities in that other people who associated with them will be exposed to those cultures or ethics.

Groups will often form so as to internalize externalities associated with its members. Internalizing externalities enables entities to better capture more of the value they generate. For example, better schools serve as collections of good students who then teach to and learn from each other. Members of social or political groups serve as collections of people who are able to provide access to and accept access from resources or opportunities provided by other members. Members of particular cultures serve as collections of people who benefit from the actions and attitudes of like-minded people.

Members of the EU benefit from having access to resources (labor, jobs), opportunities (trade in goods), social systems (welfare), etc. that being a member of the Union can provide.


Members who are small or otherwise weak may gain authority or influence by joining a group. At the same time, however, members who are large or strong on their own might lose authority or influence by joining a group. For example, “one nation, one vote” benefits smaller members at the expense of larger members in the EU.

Types of Groups

If we classify groups based on the nature of the group, then broadly speaking, there are three types of groups: residential, economic, and social.


What I refer to as “residential” groups are groups such as tribes, neighborhoods, cities, and nations in which people choose to reside. One of the primary motivations for choosing to join a residential group is for access to public goods (e.g., defense system or legal system) or club goods (e.g., local schools, amenities, or other resources).

Changes in the environment – particularly the state of the economy – as well as changes in the interactions among members – particularly the extent of homogenization, congestion, free riding or other negative externalities associated with group members – lead to both friendly (organic) and hostile (expulsion, annexation, secession) entry and exit by members.


What I refer to as “economic” groups are groups that form for economic or commercial purposes, namely businesses. In his pioneering work, The Nature of the Firm, Ronald Coase proposed that the main reason companies form is to minimize transaction costs. According to Wikipedia,

In The Nature of the Firm (1937) … Coase attempts to explain why the economy features a number of business firms instead of consisting exclusively of a multitude of independent, self-employed people who contract with one another. Given that "production could be carried on without any organization [that is, firms] at all", Coase asks, why and under what conditions should we expect firms to emerge?

Coase noted … a number of transaction costs involved in using the market; the cost of obtaining a good or service via the market actually exceeds the price of the good. Other costs, including search and information costs, bargaining costs, keeping trade secrets, and policing and enforcement costs, can all potentially add to the cost of procuring something from another party. This suggests that firms will arise which can internalise the production of goods and services required to deliver a product, thus avoiding these costs.

Coase argues that the size of a firm (as measured by how many contractual relations are "internal" to the firm and how many "external") is a result of finding an optimal balance between the competing tendencies of the costs outlined above. In general, making the firm larger will initially be advantageous, but the decreasing returns indicated above will eventually kick in, preventing the firm from growing indefinitely.

Again, changes in the environment – economic, political, and/or social – will lead to changes in the optimal structure of the firm. As such, over time businesses change in size, scope, and structure, through mergers, acquisitions, and spin-offs, as the nature of transaction costs associated with the current market environment change.


What I refer to as “social” groups are groups that form around ideological or social interests. That is, entities join social groups so as to have access to others who share their same ideological or social interests, such as religion, profession, school of thought, etc.

Entities are generally led to join particular social groups so as to have access to like-minded entities. Generally, changes in membership (entry and exit) of social groups are due to changes in the ideology of specific group members.

Group Dynamics

Why the EU Was Formed

Let’s first understand the purpose and nature of the EU, that is, why it was formed and what the structure is that it imposes on its members. The EU was formed to achieve two primary purposes: (i) “ensure the free movement of people, goods, services, and capital within the internal market,” and (ii) “maintain common policies on trade, agriculture, fisheries, and regional development.” According to Wikipedia (formatting changed slightly)

The European Union (EU) is a politico-economic union of 28 member states that are located primarily in Europe…

The EU has developed an internal single market through a standardised system of laws that apply in all member states.

EU policies aim to

• Ensure the free movement of people, goods, services, and capital within the internal market,

• Enact legislation in justice and home affairs, and

• Maintain common policies on trade, agriculture, fisheries, and regional development.

• Within the Schengen Area, passport controls have been abolished.

• A monetary union was established in 1999 and came into full force in 2002, and is composed of 19 EU member states which use the euro currency.

Referring back to the section on Benefits and Costs of Joining a Group, it would seem, then that the primary purposes of the EU are the

i. Coordination of policies and

ii. Minimization of transaction costs.

Given the large cross-border flows of people, goods, services, and capital within Europe, anyone would think that the aims of the EU would be expected to provide substantial benefits to members.

Reasons for the Brexit

Certainly, as more nations joined the EU over time, benefits in the form of lower transaction costs among member countries have increased. Figure 4 provides an illustration of the timing of nations’ ascension to the EU, together with basic economic statistics for each member country.

Figure 4

4 country stats 

Data points omitted from the graph:

     Luxembourg 2014 Exports % GDP: 203%

     Malta 2014 Exports % GDP: 149%

At the same time, however, over time the costs have increased as well, particularly those associated with loss of member countries’ independence. Over the years, the EU has passed substantial amounts of legislation by which member countries are required to abide.

Taken from “55 Years of European Legislation,” Figure 5 provides Dimiter Toshkov’s illustration of the number of directives (top panel), regulations (middle panel), and decisions (lower panel) adopted by the EU annual from its inception through 2012

Figure 5

5 eu legislation 

Figure 6 illustrates the broad scope (in the form of specification of topics) of the EU directives.

Figure 6

EU Legislation by Topic

 6 eu legislation


The media generally reports that the reason the UK voted to leave the EU was due to loss of identity and independence in general, and loss of control over immigration in particular. For example, in “Brexit 101: What just happened, and why it's important for Americans,” Everett Rosenfeld reports:

And for many, concerns about the costs of continued EU membership far outweighed any worries about leaving.

One of the major sticking points in the conversation has been immigration concerns, as some Brits worry that the country's employment market and social services will drown under the weight of too many new residents. There's also the worry that upper-crust elites and Brussels bureaucrats are pushing for a continental identity that diminishes the U.K.'s own sense of self.

There were also economic arguments, although they were more often made by pro-exit politicians than by professional economists. Those politicians argued that the EU's strong regulatory regime and its required contributions actually depress the U.K.'s growth potential.

Peggy Noonan paints a similar portrait in “A World in Crisis, and No Genius in Sight”

The EU was founded for one great reason: to redirect the energies of a continent twice convulsed by world war and turn them to peaceful pursuits—trading goods, making money, each nation knowing the other in a context of constructiveness. It succeeded! But in the past 30 years it expanded, took on more power and authority, made more demands, fell too in love with its ability to apply limits.

Theory of the Core

Members of a group form sub-groups, or coalitions, with other members based on common interests and incentives. In cases when coalitions form, an important contributor to group outcomes can be the dynamics among sub-groups of members within the group. The study of interactions among coalitions within a group is called “Theory of the Core.” The core is the set of group outcomes that are stable, in the sense that no coalition would be better off by leaving the group and forming their own subgroup. Wikipedia defines the Theory of the Core as follows:

In game theory, the core is the set of feasible allocations that cannot be improved upon by a subset (a coalition) of the economy's consumers. A coalition is said to improve upon or block a feasible allocation if the members of that coalition are better off under another feasible allocation that is identical to the first except that every member of the coalition has a different consumption bundle that is part of an aggregate consumption bundle that can be constructed from publicly available technology and the initial endowments of each consumer in the coalition.

An allocation is said to have the core property if there is no coalition that can improve upon it. The core is the set of all feasible allocations with the core property.

Generally speaking, there is a potential for conflicts when the interests of particular members or coalitions within the group diverge from the interests of the group as a whole. In the case of the EU, these conflicts arise when national interests of particular EU countries or coalitions diverge from the supranational interests of the EU as a whole. Given the large cultural differences of the member countries, one would expect many conflicts among countries and coalitions within the EU.

Noora Löfström in “A model explaining European cultural differences,” emphasizes the differences across EU member nations:

The 27 governments of member states all have different opinions, interests and starting points. Not to forget a different culture and economic performance. Being from Europe does not really unite, as Europe is the world’s most complex region and “European citizenship” is yet to evolve. I learned a while ago that five out of the six cultural “clusters” analyzed in the world can be found on our continent with 300 million people. Therefore, ”united in diversity” is a very appropriate motto.

Noora Löfström presents Hofstede’s Model as it applies to European Countries. Based on her descriptions, I created the matrix in Figure 7 below.

Figure 7

7 hofstede model 

In “(Re-)Building Coalitions: The Role and Potential of Member States in Shaping the Future of the EU,” Josef Janning and Almut Möller provide a compelling description of the importance of coalition dynamics within the EU.

Member states matter greatly in European policy- making. In their bodies – the European Council and the Council of Ministers – member state governments define strategic priorities, launch initiatives, and shape the institutional setting of the EU; they act as co-legislature, and not least (though almost invisibly), they guide the European Com- mission’s work through the many consultative processes of comitology.

Because of this, what matters even more than the member states themselves is the interaction of member states within and beyond the EU institutions: the patterns of cooperation, ad-hoc, or sectorial coalitions vis-à-vis longer-term coalitions across policy areas (groupings such as the Nordic states, the Visegrad Group, and the Weimar Tri- angle, and high-impact partnerships such as the Franco-German cooperation). Motives for building coalitions differ, from leadership ambitions to shared interests and policy preferences, from geo- graphic proximity to personal ties between leaders, from sympathetic political cultures to compatible bureaucracies.

From its beginnings, European integration has been shaped by coalition structures. At the core of the original European Economic Community stood the Franco-German entente, which also rein- forced an obvious but otherwise unlikely coalition of three smaller member states: Belgium, Luxembourg, and the Netherlands. This became evident when, with the first Northern enlargement, Dutch European policies won two more very like-minded member states: the UK and Denmark. Successive enlargements further diffused the original setting; Europe saw the rise of a “founding members coalition,” which became essential for institutional reform in the 1980s and started to disintegrate toward the end of the century. Other coalitions such as the Franco-German tandem have remained in place, but their impact was challenged once the EU expanded beyond 15 members in the early 2000s.

It seems that as a consequence of the multiplication of EU members from 15 to 25 members in less than a decade, and the expansion by three more members by 2014, the role of coalitions has given way to more ad-hoc interaction alongside a more national approach among member state governments. The resulting fragmentation appears to have strengthened the trend toward case-by-case blocking coalitions and increased veto-action by large member states. On the flipside of this trend, predictability, continuity, and commitment to the “Community approach” have been lost.

Given the vast diversity across EU member nations, not to mention the active formation and dynamics of coalitions of countries within the EU, it's surprising to me that the Union has stayed intact for as long as it has.

EU – UK Exit Negotiations

An interesting dynamic involves the upcoming negotiations between the UK and the EU covering the terms of UK’s exit from the EU. In particular, the EU has conflicting incentives regarding the terms it would like to negotiate. On one hand, the EU wants to cut a harsh deal with the UK so as to dissuade other countries from also leaving the EU. On the other hand, EU wants to negotiate a friendly deal, so as to optimize the gains to the EU from future interactions with the UK.

Which position will the EU end up taking?

Peggy Noonan recognizes this conflict and advocates for the EU offering more accommodating terms of exit to the UK, so as to affirm that “the EU is a place of peaceful commerce”:

The EU should be supple now, not brittle and predictable, which is to say bureaucratically brutal. It should surprise the world and demonstrate some give. It should grant Britain a relatively smooth exit. Let people see the decency and constructiveness of it and come to doubt their own antipathy. You’re not such a bad lot. Strategic pliancy would actually be an assertion of strength. If the European Union is a prison, as Brexit supporters felt, it makes sense for the warden to make an example of Britain to keep the other inmates in line. But if the EU is a place of peaceful commerce it has an opportunity to show it. Take it. The Brits aren’t the only ones who hate you.

The post-Brexit statement made by EU leaders, “Statement by the EU leaders and the Netherlands Presidency on the outcome of the UK referendum,” suggests that the EU may in fact take the more conciliatory path:

President Tusk, President Schulz and Prime Minister Rutte met this morning in Brussels upon the invitation of European Commission President Juncker. They discussed the outcome of the United Kingdom referendum and made the following joint statement:

"In a free and democratic process, the British people have expressed their wish to leave the European Union. We regret this decision but respect it.

This is an unprecedented situation but we are united in our response. We will stand strong and uphold the EU's core values of promoting peace and the well-being of its peoples. The Union of 27 Member States will continue. The Union is the framework of our common political future. We are bound together by history, geography and common interests and will develop our cooperation on this basis. Together we will address our common challenges to generate growth, increase prosperity and ensure a safe and secure environment for our citizens. The institutions will play their full role in this endeavour.

We now expect the United Kingdom government to give effect to this decision of the British people as soon as possible, however painful that process may be. Any delay would unnecessarily prolong uncertainty. We have rules to deal with this in an orderly way. Article 50 of the Treaty on European Union sets out the procedure to be followed if a Member State decides to leave the European Union. We stand ready to launch negotiations swiftly with the United Kingdom regarding the terms and conditions of its withdrawal from the European Union. Until this process of negotiations is over, the United Kingdom remains a member of the European Union, with all the rights and obligations that derive from this.  According to the Treaties which the United Kingdom has ratified, EU law continues to apply to the full to and in the United Kingdom until it is no longer a Member.

As agreed, the “New Settlement for the United Kingdom within the European Union”, reached at the European Council on 18-19 February 2016, will now not take effect and ceases to exist. There will be no renegotiation.

As regards the United Kingdom, we hope to have it as a close partner of the European Union in the future. We expect the United Kingdom to formulate its proposals in this respect. Any agreement, which will be concluded with the United Kingdom as a third country, will have to reflect the interests of both sides and be balanced in terms of rights and obligations.”

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