Game Theory

As I have mentioned in the past, I am involved in the Milwaukee Chapter of Company of Friends. The topic of our meeting this month was Game Theory. We were lucky to have as our featured speaker Professor Jim Miller from Smith College.

Game Theory is a field of economic study, where economists work to predict how companies and consumers are going to behave. It has become popular in the business community to help guide strategy and decision making. It has even been talked about on the silver screen. A Beautiful Mind was based on the life of John Nash, a mathematical who won the 1994 Nobel prize in economics for his work on Game Theory.

The majority of our discussion dealt with the Prisoner’s Dilemma. This is a good description from Principia Cybernetica Web:

Imagine two criminals have been arrested under the suspicion of having committed a crime together. However, the police does not have sufficient proof in order to have them convicted. The two prisoners are isolated from each other, and the police visit each of them and offer a deal: the one who offers evidence against the other one will be freed. If none of them accepts the offer, they are in fact cooperating against the police, and both of them will get only a small punishment because of lack of proof. They both gain. However, if one of them betrays the other one, by confessing to the police, the defector will gain more, since he is freed; the one who remained silent, on the other hand, will receive the full punishment, since he did not help the police, and there is sufficient proof. If both betray, both will be punished, but less severely than if they had refused to talk. The dilemma resides in the fact that each prisoner has a choice between only two options, but cannot make a good decision without knowing what the other one will do.

This same scenario can take place between two companies when determining the price for a product. If both companies choose high prices, they will split the customers and receive medium profits. If they both choose low prices, they will again split the customers, but receive low profits. If the companies choose alternate strategies, the company with the low price with take all the customers and all the profits. The high priced company with end up with no customers and no profits.

The way this normally plays out in the marketplace is competition among companies drives prices down. We talked about the Wal-Mart cover story in December’s Fast Company. The story leads with the tale of Vlasic’s $3 gallon pickle jar. Wal-Mart’s tests showed they could move a lot of product at that price point, and they challenged Vlasic to provide them a product. Vlasic did and it was a tremendous success. 240,000 gallons of pickles per week were moving through stores. Wal-Mart quickly accounted for 30% of Vlasic’s business and the $3 jar was cannibalizing Vlasic’s other customers. When Vlasic looked for relief, Wal-Mart said no and hinted they could find someone else.

Game Theory proves something we all know – competing on price is very dangerous. Some of the strategies Miller suggests to combat this were:

  • Make it difficult to compare your offerings with others – the airlines do this with frequent flier miles.
  • Innovate and offer features others can’t – this is Rubbermaid’s strategy – they introduce hundreds of new products each year making it difficult for year-to-year price comparisons
  • Build brand equity – this point was debatable, but you can see how people continue to buy Coke and Pepsi over America’s Choice and Jolly Good. It begs the question “How valuable was Vlasic’s brand?”

Extra notes:

Jim Miller’s book is Game Theory at Work: How to Use Game Theory to Outthink and Outmaneuver Your Competition (McGraw-Hill Trade, 2003).

Tom E., member of the Milwaukee CoF, provided some additional game theory resources at this link:

Thanks to Tim for catching a little error in the original post.

3 thoughts on “Game Theory

  1. I read something somewhere about price matching. Companies who claim to match a competitor’s advertised price aren’t actually competing on price, they are sending a signal to their competitors to not lower prices or face a price war. It is sort of like legal collusion. The funny thing is that consumers probably think they are getting such a great deal because of that.

    Of course, sometimes companies do this by carrying similar but differently branded items, so that prices can never be directly compared. I remember looking at Lowe’s and Home Depot for lawn mowers – they had totally different models, which makes a price guarantee easy to fulfill and still have high margins.

  2. Cool Post..but why? is it assumed that the higher priced product wins the customers? why don’t they buy the lower priced product?

    “If the companies choose alternate strategies, the company with the high price with take all the customers and all the profits. The low priced company with end up with no customers and no profits.”

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