Game theory, Price Wars and Cooperation in Strategic Decision Making
Game theory, the prisoner’s dilemma, and Nash equilibrium are important concepts that can be applied to several real-world situations. One such situation is pricing in business and industry.
An oligopoly is a type of market structure in which there are a few large firms that dominate the industry. Therefore, an oligopoly has a high barrier to entry, which means that firms have less incentive to join, owing to the fact that dominant firms already exist in the industry, and it would be difficult for new companies to join and battle for a significant amount of market share.
We can assume the examples of JD.com and Suning, which are both retail companies in China.
As the article shows, the two oligopolistic firms both have the main goal of profit maximization, and therefore, one of them, say JD.com, reduces the price of its goods with the aim of stealing Suning’s customers and market share. However, Suning notices the price reduction and reduces its own price, hence retaining its customers. The table below illustrates the possible outcomes based on the firms’ actions (values in terms of millions of dollars):
Adhering to the goal of profit maximization, it is rather likely that equilibrium will be achieved when both companies adopt the low-priced strategy, as stated in the article. This stunt by JD.com started a price war with its competitors Suning and Gome which led to this new low-priced – low-priced equilibrium.
However, if we were to consider the concept of Nash equilibrium, which is achieved when each participant adopts a strategy that is best for them, and no participant can benefit from changing their strategy, the firms would have a different approach. In an oligopoly like the industry above, Nash equilibrium exists at the point where all companies cooperate. It is in the best interest of all companies to cooperate because if they don’t, all parties end up worse off. Therefore, if these companies cooperated, there would be a high-priced – high-priced outcome ($100 million, $100 million) which is a win-win for all firms. This shows that when firms work without cooperation, it doesn’t always end up being good for them in the long run.
This can also be linked to the concept of coordinated-strategic decision-making in behavioral economics, where it is explained that firms should work together in order to benefit more rather than work separately.
Let’s consider the case of two technology giants, and let’s say a new form of technology was discovered, which could earn them profits up to hundreds of millions. A revised version of the existing old technology was also created. Naturally, with the goal in mind of profit maximization and gaining maximum market share, one would believe that if Firm A rolled out the new technology before Firm 2, Firm 1 would benefit. Though there is a chance this could happen, it depends on the kind of technology. For example, Facebook initially benefitted significantly by seeing a high rate of adoption in its networking technology as it rapidly spread across various college campuses.
However, if we consider VR (virtual reality), we can say that since its advent in the 1990s, it has not had as high a rate of adoption as expected until 2021. Additionally, in the case that a company is offered a change in its software or other widely-used technology, it is highly unlikely that they will immediately change it, because the company relies strongly on the existing software, employees would need to be educated on how to use the new software and, lastly, it is likely that the new software could have bugs. Therefore, there is a low rate of adoption of the new technology.
To battle a low rate of adoption, companies should decide to roll out the new technology at the same time to benefit more together, as shown in the matrix below (values in terms of millions of dollars):
As the matrix above shows, in the case that only one of the firms introduces the new technology to the industry, it would earn only $150 million due to low adoption rate of the product (significantly lesser than it was earning earlier), and the other firm would make $0 as its technology would now be ‘obsolete’. Hence they are both worse off.
However, if both companies bring the new technology into the industry together, they benefit greatly at Nash equilibrium, earning $600 million each, double of what they would have earned if they introduced the revised version of the old technology ($300 million each).
To conclude, through the concepts of game theory and Nash equilibrium, we can understand the severe effects of price wars, as well as the need for – and importance of – cooperation between firms.
Sources:
https://www.atlantis-press.com/article/125965833.pdf