Winning the Game: Decision-Making in Competitive Markets with Game Theory

In today’s fast-paced market, the majority of startups fail due to poor strategic decisions, which is why many hire professionals to help them come up with the best responses to different scenarios. With the help of consultants or researchers, decision-makers have to manage how the company relates with their competitors, preempt changes in the market, and utilise first-mover benefits. Continuing our game theory series, we will look into the nature behind different decision-making processes with a case study. 

In chess, the player with the white pieces plays first, and many believe that they can gain an advantage over their opponents by making the first move. Now and then, some firms will take the initiative in the market to gain a competitive edge with what economists call a first-mover advantage (FMA). First movers (FM) in an industry are almost always followed by competitors who want to capitalise on the first mover's success and gain market share. But more often than not, the FM has already established a sufficient market share and a solid enough customer base that it maintains the majority of the market.

Now consider two competing companies, Coca-Cola and Pepsi, for example. Both companies now have a decision to make: whether to cut prices or not. Assume both companies aim to maximise profits rationally. If both companies maintain their current prices, they will evenly share the market and achieve moderate profits. On the other hand, if Coca-Cola cuts prices (defects) while Pepsi cooperates, Coca-Cola captures a larger market share and earns significantly higher profits, while Pepsi loses some of its market share and profits. If both companies defect, a price war would start, resulting in overall diminished profits due to reduced margins.

In the payoff matrix, if both companies maintain their prices, they each earn $500 million. If Company A keeps its prices while Company B cuts them, Company A's profit falls to $250 million, and Company B earns $750 million. If Company A cuts prices and Company B maintains them, Company A earns $750 million, while Company B makes only $250 million. If both cut prices, they enter a price war, resulting in lower profits of $300 million each. 

In this case, assume Coca-Cola lowers its prices before Pepsi does. By cutting prices first, Coca-Cola can attract consumers quickly, establishing a loyal customer base. Once consumers are attracted to Coca-Cola, their cost of switching to alternatives increases, making it harder for Pepsi to lure them away even if it decides to cut prices later. Additionally, by achieving a larger sales volume, Coca-Cola secures a significant market share before Pepsi has a chance to respond. This FMA can then enable the firm to achieve economies of scale, reducing per-unit costs and further widening profit margins. Lastly, Coca-Cola’s early investment in lower pricing can allow it to create entry barriers that can deter future competitors from entering the market, further monopolising the market

As the saying goes, 'No risk, no reward.' However, being the first mover involves significant risks, and higher profits are not guaranteed. If Pepsi lowers its prices as a response to Coca-Cola’s defection, the companies may engage in a price war with each other. Aggressive price cutting would result in a race between the firms to cut their prices until they reach equilibrium at their lowest possible prices to remain competitive while still earning profits. Both companies would still suffer financially compared to the original equilibrium before the price cuts. In a study conducted by the Harvard Business Review,  costs related to product development, market education, and establishing brand recognition can persistently overwhelm any initial revenue advantages of the FM. If the company does not achieve sufficient market penetration or profitability in the early stages, it may struggle to sustain its operations over time. 

On the flip side, being a follower in the market also doesn’t necessarily mean you would have the short end of the stick. Companies that quickly enter the market after the FM (fast followers) can strategically position themselves to capture market share without the same risks associated with pioneering a new product or service. They can also optimise their offerings based on consumer feedback received by the FM. 

Strategic interactions are straightforward, and game theory can only do so much to predict others’ decisions. The models only work assuming all players are rational and possess perfect information. In reality, individuals may act irrationally due to emotions, biases, or incomplete information, leading to decisions that deviate from the predictions made by game theory models. This assumption can result in inaccurate predictions and ineffective strategies. In a real-life market, there are more than just two competing agents. When multiple agents and outcomes are involved, constructing and interpreting models becomes more difficult, hindering the decision-maker’s ability to come up with actionable recommendations.

To sum everything up, through the example of Coca-Cola versus Pepsi in pricing strategies, companies must carefully weigh the associated risks and market dynamics to develop effective pricing strategies and utilise their first-mover’s advantage. At the end of the day, game theory is not a foolproof method but a tool to help companies decide which strategy is the most suitable for them. It’s more sustainable for decision-makers to adapt to the ever-changing market conditions than to blindly follow a set of theories.

Sources: 

Brickley, J., Smith, C., & Zimmerman, J. (2000). AN INTRODUCTION TO GAME THEORY AND BUSINESS STRATEGY. Journal of Applied Corporate Finance, 13(2), 84–98. https://doi.org/10.1111/j.1745-6622.2000.tb00056.x

Coca-Cola, PepsiCo, and the Prisoner's Dilemma. (2019, September 25). Cornell University. https://blogs.cornell.edu/info2040/2019/09/25/coca-cola-pepsico-and-the-prisoners-dilemma/

Investopedia. (n.d.). What is a first mover? From https://www.investopedia.com/terms/f/firstmover.asp

Dixit, A. K., & Nalebuff, B. J. (2010). The Art of Strategy: A game theorist’s guide to success in business and life. W. W. Norton & Company. 

FasterCapital. (n.d.). Limitations and challenges of applying game theory to competitor analysis. From https://fastercapital.com/topics/limitations-and-challenges-of-applying-game-theory-to-competitor-analysis.html

Acharya, D. (2023, August 2). The price of first movers: Unlocking the risks of being a trailblazer in the tech industry. Forbes. https://www.forbes.com/councils/forbestechcouncil/2023/08/02/the-price-of-first-movers-unlocking-the-risks-of-being-a-trailblazer-in-the-tech-industry/

Boulding, W. (2014, August 1). First-Mover disadvantage. Harvard Business Review. https://hbr.org/2001/10/first-mover-disadvantage