Managerial Economics - Group(Y) Project

Is Price War A Dominant Strategy for Oligopoly?

Submitted by:

Rohit Gupta(EPGP-09-151)
Sachin Mittal(EPGP-09-154)
Reuben Rajan(EPGP-09-150)
Raghavi Dhamodharan(EPGP-09-139)
Acknowledgement
We the students of EPGP 09 batch would like to extend our
sincere thanks to the institute IIMK and Professor Shubhasis
Dey for providing us the opportunity to study and understand
the oligopoly and various strategies being used by them.

Abstract
This project illustrates that in duopoly market, price war may
not be the dominant strategy to gain market share; the way two
cola giants, Coke and Pepsi, had moved from price war to
advertisement war as analyzed via Nash Equilibrium and Game
Theory.

Introduction

Industry overview
The non-alcoholic beverage industry broadly includes soft
drinks and hot drinks. Soft drinks contain carbonated or non-
carbonated water, a sweetener, and a flavor, and hot drinks
include coffee and tea. The soft drink category dominates the
industry and includes carbonates, juice, bottled water, ready-to-
drink tea and coffee, and sports and energy drinks. Soft drinks
are sometimes referred to as liquid refreshment beverages (or
LRBs). In the US, LRBs lead food and beverage retail sales

Major companies
The non-alcoholic beverage market is a highly competitive
industry that includes two behemoths The Coca-Cola
Company (KO) and PepsiCo, Inc. (PEP). Collectively, these
companies hold about 70% of the US CSD market. Dr Pepper
Snapple Group, Inc. (DPS), Monster Beverage Corporation
(MNST), and Cott Corporation (COT) are some other key
players in the CSD market.

Many international markets are also dominated by Coca-Cola

and PepsiCo, but include other companies such as Groupe
Danone, Nestle SA, and Suntory Holdings Limited.
Stimulants in soft drinks
People crave soft drinks because they contain two stimulants
sugar and caffeine. Also, the water in soft drinks hydrates. Soft
drinks contain considerable amounts of sugar, which is a form
of carbohydrate. Consumption of excess sugar releases a
hormone called dopamine, which induces pleasure in the brain.
Caffeine, another key ingredient, stimulates the nervous
system, and helps you to stay awake or restores alertness.
With its slightly bitter taste, caffeines also used to enhance the
flavor of carbonated soft drinks.

Ingredient facts
The Coca-Cola Company (KO) and PepsiCo, Inc. (PEP) are the
leading soft drink manufacturers. A 12-fluid ounce can of Coca-
Cola contains 39 grams of sugar and around 34 milligrams of
caffeine. A 12-fluid ounce can of Pepsi contains 41 grams of
sugar and 38 milligrams of caffeine. A 12-fluid ounce can of Dr
Pepper, made by Dr Pepper Snapple Group (DPS), contains 40
grams of sugar and 41 milligrams of caffeine. Energy drinks
made by leading companies such as Monster Beverage
Corporation (MNST) contain higher amounts of caffeine.

Coca-Cola and PepsiCo duopoly

America, were a nation with

rivalries of its democratic
tradition in which Coke and
Pepsi had no choice to
escape, they have shown
how they were in normal
warfare and while time pass by they went on to unhealthy way.
Coke and Pepsi changed the consumers perception by the
way they were conducting their business. E.g Cokes
destructive price war in 1980s.
It started in early 1970s they were offering similar products with
the same look and taste. Even though they had price
diversification, product alterations and upgradation practices
kept them rejuvenating the market, they faced pressure for
more innovations, something differ from each other to gain
competitive advantage. They started with price war and moved
towards Ad War and marketing of products was the path
chosen to generate competitive advantage and public interest.
They realized Advertisement war would be the best strategy
than price war to achieve their goals effectively.

Price war between Pepsi and Coke

Bertrands duopoly model is the strategic game with solution of

non-cooperative equilibrium. This describes the competition in
duopolistic market in terms of price when selling identical
product, assumed to select price level in ignorance of other
action. Each firm choose a price and produces enough output
to meet the demand it faces, given the prices chosen by all
firms.

If n-firms produce the single good, in which each firm can

produce q units of good at a Cost of C.
D, being the normal demand function to specify demand of
the product.
D(p), is the total amount demanded when the good is
available at the price p.

In case of different price settings, consumers will naturally

purchase from the lowest price selling firm, where output meets
the demand.
If more than one firm sets the lowest price, the demand
will be shared at equal price
If a firms price is not the lowest price received then there
will be no demand and firm produces no output.
Then just to satisfy their demand each of the firms will produce
that much output only.

Setting up for the Bertrands duopoly strategic game:

Players: Duopoly Players

Actions: Each firms set of actions is the set of possible prices
Preferences: Each firms preferences are set by its profit.
Various aspects of price war

As we discussed in the beginning, to take control over the

market and gain competitive advantage their rivalry is very
important. Bertrands model of duopoly will be used as a tool to
explain the decision making and competition in terms of prices,
and possible conflict resolution between Coke and Pepsi.

1. Players: Coke and Pepsi

2. Actions: Each firm set of action is set of possible prices
p1-Coke and p2- Pepsi
3. Preferences: Each firm wants to maximizes its profits

Lets set up a no cooperative strategic game between Coke

and Pepsi in terms of the price. Without knowing in advance
about their competitors action plans each firm will set its own
price. A lower price than its competitor should be set in order to
obtain profit, and they wont set price lower than their
production cost of a bottle. Even if Coke and Pepsi set their
beverages under a different name, all of the consumers know
that the product that they sell is exactly the same.

Demand for the beverages:

P= a Q (Q=a-P) and TC=CQ

Where, P is the price of bottle of the beverage, and Q
(Q=q1+q2) is overall quantity of Coke and Pepsi beverages
sold by two firms respectively, and a is a constant. TC is
assumption that we deal with constant cost C.

If the cost of producing one bottle is 50 cents, for both Coke

and Pepsi.Being profits maximizing firms. If p=c firm makes no
profit, because the cost of producing each unit is same, equal
to c,firm Y (Coke) makes the profits p1-c and firm two X, Pepsi,
makes the profits equal to p2-c.

Profits = Revenue-Cost

= p*q-cqand p=0 if p<c

= ( p1-c) (a-p1 ) for Coke

= ( p2-c) (a-p2) for Pepsi

Discussion on Profits
1) If Coke charges $1 for bottles of coke and Pepsi
charges $2 for bottle of Pepsi then Coke takes all profit
which is $1.50 per bottle:

Ifp1<p2 then X= ( p1-c) (a-p1)

(On contrary, if Pepsi (Y) charge lower price per bottle

than Coke (x), it would obtain all profit and Coke would
get nothing)

2) If Coke charges same price as Pepsi for one bottle of

drink, lets say $1, then they would share profit. Coke
would make 50 cent per bottle so would Pepsi

If p1=p2 then X=1/2 ( p1-c) (a-p1)

 3) If Coke in this case decides to charge $2 per bottle of
drink and Pepsi charges $1 per bottle of drink then
Coke would not make any profit:

If p1>p2 then X=0

(Vice-versa is also true)

From the previous example we could see that the firm which
charges the lower price will obtain all profit, and other firm
which charges higher prices per bottle of drink will get No Profit.
Now we have seen what the profits of each firm are, but in
order to find Nash equilibrium, first we need to find firms best
response function given what other company does.

Best response function

1) 1)$1/ bottle charged by Pepsi and 80 cents/bottle of

Coke (Knowing Pepsi strategy),best response by Coke
is represented by:

Bx (py) = p1<p2 if p2>c

If same strategy will be taken by Coke:

By (px) = p2<p1 if p1>c

2) 50 cents/bottle charged by Pepsi and Coke alike, will

give below best response:

Bx (py) = p1=p2 if p2=c

Same is true,

By (px) = p2=p1 if p1=c

In order to get profits both of them could lower their costs, but
at the end their price would be equal to cost p1=p2=c.
In cooperative strategy they could set the monopoly price in
order to make higher profits.

Conclusion: How Price war ended as dominant strategy

Bottom line from above is that this long term price war between
Coke and Pepsi would probably may not be healthy for duopoly
market as if both the players reduce selling price they may end
up in less revenue and if one of the player decreases price,
other will follow the suit to keep the market share.

Hence, dominant strategy in this case is to keep the price high

and fixed and follow the marketing strategy (advertisement) to
increase market share.
Each firm has two basic strategies: Either charge a high price
or a low price for its products. Either firm could score a big
payoff by charging a low price while its competitor charges a
high price, but both firms know that if one of them cut its price
the other will quickly follow suit, resulting in a smaller payoff for
both firms. The resulting equilibrium is both firms charging a
high price and engaging instead in non-price competition.

Explanation of the dominant strategy with payoffs.

Pepsi charges Pepsi charges
high price low price

Coke charges Coke makes large profit Coke takes a loss

high price Pepsi makes large profit Pepsi makes normal profit

Coke charges Coke makes normal profit Coke makes small profit
low price Pepsi takes a loss Pepsi makes small profit
Above pay-off matrix proves that both the firms must charge
high price and is the dominant strategy.

Moving to Non-Price as dominant strategy

Advertisement as dominant strategy

So instead of moving further in price war both the players in

duopoly had moved to Advertisement war considering it
beneficial and fixing price at optimum level.
Further competition started in Advertisement world and let to
Advertisement war.

Further Analysis

Game theory predicts that the companies will match each

other's moves: if Coke hires a pro athlete to endorse its
products, Pepsi will hire a TV star. If Coke changes its formula,
Pepsi will launch an all-out TV campaign to make fun of it. If
Coke sponsors the Super Bowl, Pepsi will sponsor the World
Series. The conclusion to be drawn is that in an duopolistic
market, failure to react to a competitor's move will allow the
competitor to capture market share and increase its profits.
Advertisement Expenditure Worldwide

PepsiCo Advertising Expense

Coca Cola Advertising Expense

Explanation of the dominant strategy with payoffs.

Pepsi Pepsi
Advertise Doesnt Advertise

Coke Max Profit, Max Profit Max Profit, Min Profit

advertise

Coke Min Profit, Max Profit Normal Profit, Normal

Doesnt advertise Profit

Above payoff matrix explains advertisement is the dominant

strategy for both the players.
Comparative stats of Advertisement expenses

Due to the nature of the Industry, Coca-Cola has made a yearly

commitment to large ad spends, spending a total $3.499 billion
in 2014, $3.266 billion in 2013 and $3.342 billion in 2012.

Coca-Cola's advertising spend accounted for 6.9% in total

revenue for each year from 2012 to 2014. At the end of the
year in 2014, Coca-Cola was the largest advertiser in the
beverage industry.

This large advertising spending has allowed Coca-Cola to gain

a competitive advantage in key areas. Its advertment spending
and strategy has helped it successfully introduce new products
into the marketplace, increase brand awareness and brand
equity among consumers, increase the knowledge and
education of consumers, and increase overall sales.

In comparison to Coca-Cola's yearly spending, PepsiCo spent

$2.3 billion in 2014, $2.4 billion in 2013 and $2.2 billion in 2012.
Conclusions

It can be easily concluded now, how the companies started with

price war are ending up in Marketing war (Advertisement), as
pricing may not be the best strategy and may lead to losses for
the companies.
Now the companies are looking at various strategies in
Advertisement war.
Large advertising spending have allowed companies to gain a
competitive advantage in key areas.

Figure: Advertisement Impact in Australia

References

The-coke--pepsi-rivalry-in-indian-markets- by
MilanaBorisev
http://www.investopedia.com/articles/markets/081315/look
-cocacolas-advertising-expenses.asp
http://marketrealist.com/2014/11/understanding-
consumer-craving-soft-drinks/
https://www.chartist.co/charts/55956
https://www.statista.com/statistics/286547/pepsico-
advertising-spending-worldwide/
https://www.statista.com/statistics/286526/coca-cola-
advertising-spending-worldwide/
Pearson Series in Economics- Robert Pindyck, Daniel
Rubinfeld-Microeconomics-Prentice Hall (2012)
http://www.economicsdiscussion.net/oligopoly/bertrands-
duopoly-model-with-diagram/5396
ICFAI Center for Management Research , 2001: Pepsi vs.
Coke
Images courtesy Google.