Price War – An Application of Game Theory
It is common for competitive big companies to raise price wars against each other, which means those companies manage to capture more market share by repeatedly cutting prices of a kind of product that they are all selling. Since the prices always go down, a company would gain a negative profit if its price is below the cost of manufacturing. However, they dare not quit the price war – at least not too soon – or they might lose a lot market share, as well as the its reputation and repeat customers. This can be destructive for relatively smaller companies and companies that can not afford to burn a lot of cash quickly.
The price war can be represented by the game theory. Assume there are only companies A and B in the market, and they both have two choices: to continue the price war (by keep lowering the price, A1 and B1), or to quit the war (stop lowering, A2 and B2). Assume the prices of the product are approximately the same for A and B, and the price is currently below the cost of making the product.
A \ B B1 B2
A1 (-5, -5) (10, -10)
A2 (-10,10) (0, 0)
*Values are chosen randomly
Explanations for each case:
(A1, B1), both A and B keep burning money on lowering the price, and they are assumed to both lose “5” if they keep doing it;
(A1, B2), A keeps burning cash while B stops. A would earn a positive profit in the future because A captures the market share that B lost and the price can be raised, although the more A produces, the more A loses, for now. Since B quits and loses a lot market share that is difficult to be captured back, B should lose more money than 5 in the future;
(A2, B1), the counter of (A1, B2);
(A2, B2), if A and B stop the war and raise the price back to normal almost at the same time, none of them loses money any more. They might earn a profit though; 0 and a small positive number (less than 10) should be equivalent.
From what we learned in class, A and B should both choose to keep the war on, because that is the dominant strategy for them. However, if one of them finds it intolerable (i.e. does not have any more money to burn) to fight the price war, that company would naturally quit or look for more investment. But usually the war would not go on forever.
Here is an example of the price war: the two biggest IT companies in China, Alibaba (which just launched its IPO in Nasdaq) and Tencent once fought against each other in the market of taxi app in China. Both of them captured about half of the market share before the war, and amusingly, afterwards. They encouraged people to use their apps and thus to stay on their app’s platform by subsiding both users and taxi-drivers. At first the amount of subsidy for each transaction was small. Nonetheless, the amount of subsidy kept growing for about 6 months. It even made a considerable amount of rides for passengers free, meanwhile the taxi-drivers also earned more than the taxi price. Finally, both of them called off this insane war almost at the same time, and reduced the subsidies to a normal level, leaving hundreds of thousands of customers complaining about the reduction, while they still have to use one of the two.
Sources:
http://www.ft.com/cms/s/0/6bae3d98-2497-11e4-9224-00144feabdc0.html#axzz3EmBZyIZ5
http://www.pymnts.com/news/2014/chinas-alibaba-and-tencent-call-off-taxi-app-war/#.VCo7vhCulgk