Common logic holds that it's always good to be strategic. The more carefully a business thinks about its strategic options, the better its choices should be. But what if there's an upper limit on just how strategic it pays off to be? Can overthinking your strategy backfire?
Nathan Yang, associate professor of business administration at Gies Business, has published “The Cost of Strategic Thinking,” a new working paper that suggests the pressure to out-strategize competitors can itself become a source of inefficiency costing firms far more than the competitive threat they were worried about.
The paper models what happens when a firm overestimates the strategic sophistication of its rivals and responds as if a bigger threat is coming. In doing so, Yang is probing our shared assumptions about the market.
"Competition forces tend to be viewed as pushing firms to be more nimble, more cost efficient," Yang explained. "But what if competition drives firms to behave in ways that are actually suboptimal? The very force we think is making the economy better could actually be incentivizing firms to take less efficient actions."
Level-K Thinking
Yang's model is based on a concept from behavioral economics and game theory called "Level-K" thinking. Level-K is a theory that attempts to explain how players make decisions in strategic interactions. A player at "Level 0" isn't using any strategic planning at all: typically, they're following a "rule of thumb" or a simple plan. When the market goes up, they go in.
A "Level 1" player, one rung up the ladder, assumes that their opponent is playing at Level 0 and plans around that assumption. That progression goes up the chain: a "Level 2" player assumes their opponent to be a "Level 1," and so on. All's well and good with that way of thinking until a firm (or in game theory's terms, a player) makes moves at a Level 2 or higher when their competition is, in fact, still at Level 0. The higher-level firm might invest in deterrence, or strategic options - like expanding its network, building up capacity, or signaling - to discourage a competitive move that just isn't coming. It's like trying to think three steps ahead in chess when your opponent hasn't even taken a move yet.
That misunderstanding can have consequences. For a firm that made choices based on assumptions about market competition that didn't pan out, strategic overthinking can mean time, money, and labor costs. Yang's model formalizes that as the gap between the payoff a firm expects to gain based on its rivals and the payoff it actually receives in light of that rival's actual behavior.
"It's like expectation versus reality," Yang said. "You can construct this measure for the expectation versus the reality. That's what I tried to do here."
A bit of strategy can be a dangerous thing
Yang's model shows that the cost of overestimating your opponent's strategic savvy can result in losses an order of magnitude greater than the "business stealing effect" - the straightforward loss resulting from a competitor snagging some of your market share.
"The cost of your competitor eating your lunch is not nearly as bad as the long-run discounted value of your strategic miscalculation," Yang said. "That's one of the most interesting insights - that cost is of many magnitudes more significant than just a contemporaneous business-stealing effect."
When a firm makes a "deterrent" investment based on incorrect assumptions about its competition - a food chain opening a new location, for example - the losses go beyond today's costs. Those sunk costs carry forward: the firm made choices, spent resources, and changed its posture for a threat that never came. Multiply that cost by years, and the cost of strategic overthinking can really add up.
Yang's model suggests another surprise: the size of the mistake doesn't scale. It might follow logically that greater levels of strategic mismatch - like a Level 5 firm facing off against a Level 0 rival - would be greater mistakes. But Yang finds the opposite: the marginal cost of additional sophistication disappears quickly.
"The cost of overthinking is most pronounced at the low end," Yang explained. "So basically going from super unsophisticated to just slightly more sophisticated, rather than someone who's already kind of strategically sophisticated becoming even more sophisticated."
That means that firms don't have to wildly overestimate the competition's strategic capacity to see losses. A little overconfidence about a rival's sophistication can be enough. And crucially, additional levels of strategic reasoning add little insight -while raising the risk of overreacting.
Yang added that the working paper was theoretical, but that news in the "real world" illustrated some of the ideas in his work.
"You see this right now - a lot of these big retailers are closing en masse," Yang said. "The common story is that the internet killed them all, or that Amazon killed them all. But maybe it was just that they were aggressively spending without a good reason."
In Level-K terms, those outlets may have been taking actions to hedge against a perceived rival - like customers moving online - that overestimated the strategic intent of that rival.
Yang's conclusion is that strategy is far from pointless - but moderate strategic sophistication captures most of the value. Deeper levels of strategic reasoning, however, begin to add risk.
"Realistic expectations about rivals," Yang says, "matter more than very deep strategic reasoning."