Usefulness of Game Theory in Product Pricing

Usefulness of Game Theory

Game Theory is a concept that allows you to clearly evaluate how your opponent may respond to your actions, and the outcome of these set of actions. Based on these evaluations, you would choose an action you would believe that best benefits you, based on how you think your opponent behaves. In a perfect world, if you do know your opponent’s actions beforehand, then you can ensure to maximize your own payoff. However, this is not always the case, and you’re often forced to predict your opponent’s behaviour.

The Prisoner’s Dilemma is a well-known game theory concept and is a useful tool for decision-making. We can see this concept being used in product pricing between competing companies. An example is between two giants in the soft drinks market, Coca-Cola and PepsiCo.

Product Pricing and the Prisoner’s Dilemma

Coca-Cola and PepsiCo are each other’s largest competitor. Both companies are always in competition to retain their own customers, while also trying to pull in new customers from each other. A common way to do this is by adjusting the product price.

In the case where one of these companies is looking to cut the price of its soda, the competing company is forced to do the same to stay competitive. We can visualize this in a payoff matrix, such that the two strategies are cooperate or defect. These are defined as follows:

• Cooperate: Company keep the original price
• Defect: Company choose to drop its price

We defined the price drop as defect in the payoff matrix because the company is choosing to break an implicit agreement where the price is kept high to maximize profits for both companies. The latter is defined as cooperate as the company is fulfilling the implicit agreement.

The payoff values in the matrix are estimated hundreds of millions of profits the company will earn. Here we see:

• If Coca-Cola and PepsiCo keep the original prices, both will mutually benefit with equal payoff
• If one of them has a price drop and the other does not, then the company with the price drop earns a significant payoff
• If both have a price drop, they both benefit with equal payoff but it’s slightly less

Here we see a prisoner’s dilemma in that there is strong incentive for a company to defect even though cooperating should yield the best results according to this matrix. In most cases, companies will act in their own self-interest so the strategy (cooperate, cooperate) is usually not chosen.

What does end happening is that both companies continue to drop prices until an equilibrium is reached where the price is reasonable for the consumer but the profit margins for the company are still sustainable.

Source

Picardo, E. (2022, May 22). The prisoner’s dilemma in business and the economy. Investopedia. Retrieved November 18, 2022, from https://www.investopedia.com/articles/investing/110513/utilizing-prisoners-dilemma-business-and-economy.asp