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Chain Store Paradox

In the “chain store paradox”, proposed forty years ago by Reinhard Selten, chain stores must decide whether to fight emerging entrepreneurs with price wars or to simply coexist. By using game theory, Selten theorized that there were two possible options: 1) launching a price war with an emerging company to prevent others from joining the market, or 2) let the competitors exist. In the first option, the chain market is betting that the emerging company could not compete with such low prices and will eventually drop out, but there is no guarantee that this will work. In fact, if it doesn’t work, then the chain store is making it even easier for others to enter the market, and may in fact lead to their own demise.

This is a very intriguing situation, because there is no one correct answer. Large retailers such as Amazon have entered price wars to try to drive out competitors, and this strategy has worked well for them, causing them to beat out Zappos and many other competitors. While price wars ensure that consumers always get the lowest prices possible, they also cost the company a huge portion of their profits, and if a company does not have a large-enough share of the market, they may end up bankrupt.

On the other hand, companies such as Apple employ the second option of the chain store paradox, in which they refuse to enter a price war, and instead continue to offer high-quality products, while allowing competitors to exist. In this case, Apple has allowed other phone and computer companies to exist, and improves their products based on what features consumers are looking for. This is a really good strategy, because it means that Apple is not losing money by fighting for consumers, and that they can continue to offer high-quality goods without cutting corners to make ends meet. This also gives other businesses the opportunity to sell goods and make money off of such a lucrative market.

While both strategies exist today, there is no one correct answer, and the options really depend on what a company is looking for. According to game theory, companies should simply let their competitors exist, whereas common sense says you should act aggressively and cut off competitors before they become too strong. Either way, the chain store paradox plays an instrumental role in the strategies that companies today employ, and it will be interesting to see how both Amazon and Apple’s strategies turn out in the long run.

Sources:

http://www.bdlive.co.za/opinion/2014/09/25/common-sense-trumps-theory

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