"Can a retailer "cooperate" with his/her competitors so both succeed and make greater profits?" This is the question posed and discussed by Pragmatic Marketing expert Mark Stiving in his recent article, Pricing and the Prisoner's Dilemma. The prisoner’s dilemma (which originated in game theory) represents a situation where two players both do better when they cooperate, even though they have incentives not to cooperate. It isn't lost on pricing expert Stiving that this approach is highly applicable to competitive pricing. Stiving shows that if you and your competitor price high and don't undercut each other you each gain more profit.*
Upstream Commerce: First, tell us about The Prisoner's Dilemma:
Mark Stiving: Imagine you are arrested by the police for robbing a bank. You, of course, are innocent. They also arrest another person for the same crime. In the interrogation room, the police say, “We’ve caught your accomplice. You guys are in trouble. You should confess now to make your sentence easier.” Then they explain the possible sentences:
* If both you and the other person confess, you each get three years in prison.
* If neither of you confesses, you each get one year in prison.
* If you confess and the other person doesn’t, you go free and he spends five years in prison.
* If the other person confesses and you don’t, he goes free and you spend five years in prison.
UC: What do the "prisoners" have to consider?
MS: If the other person confesses, you will get three years if you confess and five years if you don’t. So, it makes sense to confess, right? But what if the other person doesn’t confess? Then you will get one year if you don’t confess and go free if you confess. Again, it makes sense to confess.
It seems that no matter what the other person does, you’re better off confessing. BUT the same logic is true for the other person and you both suffer as a result. The rational outcome to this game is always for both parties to confess, thinking you could go free rather than serve any time. But, this will happen only if the other person doesn't confess, and they are thinking the same thing that you are. So, even though they are better off cooperating with each other, individual incentives encourage each to confess.
UC: What happens if you apply this dilemma to pricing?
MS: Assume you and a competitor have an equal share in the market and are both doing well, enjoying relatively high prices with nice profit margins. If you lower your prices, the payoffs will look like this:
* First, if you both cooperate and keep prices high, you each make $10 million in profit.
* If you both compete and lower prices, you each make $5 million in profit.
* If you lower prices and your competitor doesn’t, you make $13 million in profit and your competitor only makes $2 million.
* If your competitor lowers prices and you don’t, your competitor makes $13 million and you make $2 million.
UC: What is the dilemma in these pricing scenarios?
MS: In every scenario, it would seem that you are better off when you lower your price. But the catch is that the same is true for your competitor.
Thus, if you both lower the price, you each make only $5 million in profit.
However, if you could find a way to cooperate, without either of you lowering your price, you would each end up with $10 million!
UC: What might happen if your competitor lowers prices and you follow suit?
MS: Lowering prices isn't always a competitive move; for example, your competitor may have a one-time need to get rid of some inventory. But if competitors don’t realize the price decrease is temporary, they might lower prices and all end up with a permanent price decrease.
And, if you compete aggressively, as in lowering prices, odds are good your competitors will also compete aggressively, and neither of you will make as much profit.
Remember, says Stiving, price wars are easy to get into and hard to get out of.
Bottom Line for your Bottom Line:
MS: When I’ve conducted classroom exercises where two “companies” compete in the repeated prisoner’s dilemma by raising and lowering prices, the following inevitably holds true: The most profitable companies are those allowing their competitors to make a profit too.
The best news is that, in today's competitive pricing game, with sophisticated price intelligence solutions, players can play over and over and base decisions on scientific data. You may set a price this month, next month, the month after and so on. And, as you gather accurate data and see what your competitor did, you can make subsequent decisions timely, wisely and profitably.
Moral, according to Mark Stiving:
If your goal is to put your competitors out of business, be prepared for your own profits to suffer too.
See more from Mark Stiving at Pragmatic Marketing.
*Regarding collusion or price fixing. Stiving rightly notes that it is illegal to collude with your competition to keep prices high. He goes on to say: You and your competitors should never discuss pricing in any format. However, by understanding the prisoner's dilemma, you will better understand what economists call "implicit collusion." This is when industry prices stay high because no competitor acts aggressively. In other words, competitors seem to cooperate without colluding.