Game Theory in Pricing

As firms grow in sophistication with their pricing capabilities, at some point they exhaust the opportunities that internal to their company, and start looking outside to explore the dynamics of the industry.  That’s where they first encounter game theory, though many struggle with how to apply it to their strategy.

What is game theory?
In short, it’s the idea that the landscape is made up of rational players, and that they will act on their own and react to your decisions over time.

So how does that apply to pricing?
It’s easiest to start with a thought experiment:  What if they were as smart as you are?  Here’s a case study from a recent engagement.

A retailer we’ll call “Widgets” with a competitor we’ll call “Gadgets” make up over 60% of a category, with the remaining 40% being highly fragmented.  We found that the category had a high elasticity- meaning reducing price will grow volume to the extent both sales and profit would go up.  Great news, right?

The Easy (but wrong) Answer: Take Price Down!

But Gadgets has not taken price down, and if we assume they’re as smart as we are and have measured their elasticity, they must be holding price intentionally.  Why?

If Gadgets were to reduce price in a meaningful way across the board, that would put Widgets in a jam: they could leave prices alone and watch sales and share drop, or match the reduction to maintain their volume.   Neither outcome is great, but matching the lower price and maintaining topline is much less painful.

So where would both of them end up?  Selling the same volume relative to each other, but with less profit in the category.

Now let’s explore the other direction: what would Gadgets do if Widgets took price up?  Well, the same situation but in reverse.  Gadgets is likely to follow with a corresponding increase, expanding profits for everyone.

Slightly more nuanced (but still wrong): Take Price Up!

As we told them, “be careful you don’t price yourself right out of the business!”  There are certainly other considerations:

1) The creeping 40%
Though Widgets thought of themselves as being in a fight with Gadgets, in fact there was always the collective impact of the rest of the market.  As Widgets and Gadgets chase themselves up in pricing, the little guys that make up the rest of the market will slowly gain share.  They’ve just been handed an price gap by the big guys, and taking share is a huge win.

2) Desperation
The minute either Widgets or Gadgets start to feel some heat, the implicit agreement is at risk.  Be ready to revert price when the “deal” falls apart.

3) Oh yeah, the Customer
And of course, there’s always risk of customer backlash when price tags go up.

The reasonable answer: Slide prices up slowly, and watch for ill effects.

As is often the case with pricing projects, the best answer is rarely the one that comes straight from the math.