How Game Theory Affects Retail Pricing
Retailers like P&G and Unilever must strategically price their items in an effort to increase profits and attract consumers away from competitive products. One way that they do so is by using frameworks from game theory. Using game theory for pricing consumer packaged goods has been common in the past few decades. In 1991, P&G introduced a label for “everyday low pricing” or EDLP. This would consistently discount a line of products rather than using temporary discounts that caused issues like the “bullwhip effect” when huge changes in demand eventually increase production costs due to resource variability.
Was this decision well-informed? How would it affect their profits? And how would competitors respond? We can view this situation in the context of game theory. In this situation, the players in the game are P&G and Unilever, each hoping to increase the payoffs or profits that they can make by selling their goods. In the simplest regard, the strategies for the players are two-fold. They can sell “Low” and discount their products, or, they can sell “High” and gain a greater profit margin from each good sold. Let’s say for example that they are each selling a new laundry detergent that is similar in quality to each other. The companies could both sell at High, and they would split the large profit margin among themselves. However, if P&G sells the new detergent at a High price, and Unilever sells low, no customers would buy P&G’s product, leaving them with zero profits. This creates a risk that P&G is not willing to take– a bet on pricing High could leave them completely empty-handed. Thus, we have a Nash equilibrium for both players to price Low, and they will split the relatively lesser profits evenly.
In class and in the textbook, we defined Nash Equilibrium as a set of strategies where each is the best response to the other. We know this is a Nash Equilibrium because no player has an incentive to move from playing Low. The other options are not NE: if Unilever chooses to price High for example, P&G should price low and if P&G prices low, Unilever should then move to price Low.
So what’s the takeaway? Both companies should price low, allowing each to take a share of the profits available in the market. The margin is less than optimal than if each had priced high but Nash Equilibrium does not guarantee that the sum of the payoffs is necessarily the highest of any strategy combination. This is very similar to the prisoner’s dilemma where both should confess, taking little time in prison rather than a more extended period of time. Certainly, both could have gone off scot-free with no time in prison, but that would not be the dominant strategy. This optimal choice in retail pricing is reflected in true retail stores, as prices tend towards the marginal cost. And we see that under competition, both prices and industry profits will decline.
Sources:
http://mba.tuck.dartmouth.edu/pages/faculty/robert.shumsky/gametheorymodels.pdf
https://www.cs.cornell.edu/home/kleinber/networks-book/