Price wars

4. Information structure.

Both sides know strategies of each other, what each player does and what everybody will get. Hence, we have the game with perfect information. 
 

5. Rules of the game.

In this game we have sequential decision-making process, i.e. firstly decision is being made by the Company A, and then RC chooses between E and S knowing the decision of the previous player. 

     Hence, we can present this game in extensive form (Figure 1). Subgame perfect equilibrium is marked in the figure.

3

5

4

4

Payoffs of A

Payoffs of RC

2

2

    Company A

                Price war? 

     RC

                Enter the price war?

N

W

S

E

 
 
 

     

S

 
 
 
 

     Figure 1. 

     As we can see the SPE is following:

     Company A: W

                   RC: (S,E)

     To prove that this SPE is also a unique Nash-equilibrium, present this game in strategic form (Figure 2):

     

     Figure 2.

     The total payoff of the strategy is 3+5=8. It is the same if RC chooses E. So the decision of RC doesn’t influence the total surplus, but determines distribution of payoffs. 
 
 
 

2. Reaction functions

     Furthermore, actions of the players can be described by reaction functions. Assume that it is price competition on the market with substitute products. Thus we have two lines with positive slopes. The strategy of price war used by rivals of the Ritz-Carlton can be reflected as a shift of its reaction function to the left (1). After the action of the Company A, RC decides to invest money in advertising, so because of increase in sales linked with this process (Figure 4), its reaction function moves up (2). As it was mentioned in the description to the situation, the slash in the prices of the company A damaged its brand equity and led to decline in sales, what consequently led to increase of RC’s profit. Thus this process can be interpreted as negative spillover for the company A, but positive one for RC, which entails that R_RC continues moving up (3). 
 

3

2

1

P_A

P_RC

R_RC¹(H)

R_RC(H)

R_RC(L)

R_A(H)

R_A(L)

 
 
 
 
 
 

P_RC

Figure 3.

P²_RC

P¹_RC

MR

AR

MC

Q_RC

 
 
 
 
 
 
 

Figure 4.

     Now let’s identify types of strategies of our players.

     Investment of player 1 is extent of price reduction (that’s why the left reaction function of A represents high level of investments).

     It is a hard investment as it results in aggressive behavior (price reduction). In our SPE the company acts aggressively using high level of investment in order to create aggressive response and get a larger market fraction. This strategy reflects the idea of the Top Dog strategy.

     But the second player (RC) also acts trying to maximize its payoff. So its investment can be determined as extent of advertisement, that’s why the higher reaction function of the player reflects high level. It is soft investment as it leads to passive response. In our game it acts passively using high level of investment, thus its strategy can be identified as Fat Cat strategy.

     Looking at the Figure 3 we can notice that the strategy of RC of not entering the price war is the best which it can choose in conditions of price war, because in this case the hotel increases its profit, what won’t happen if it enters the war (R_RC goes down leading to decline in profit).

 

     Conclusion 

     During their existences companies face a huge number of obstacles which they have to overcome to stay alive. A start of price war is one of such obstacles whose importance can’t be neglected since participation in this war can as make a company a leader as lead it to bankruptcy.

     All economists exploring this phenomenon appeal to be very careful and make a reasonable decision. Firstly, managers should find out the nature of the price war started against his company: if it is intended or just a result of spontaneous events and has only short-term intension. In the second case managers should, put it simply, just relax and wait for the end of this actions. But if the first case occurs, it is time to be subtle and creative.

     In the chapter with general information we provided reader with information about possible tactics in the period of price war. A reader can notice that exactly non-price actions are mostly emphasized. Choosing price strategies is an obvious way of acting. They can be applied but in very careful way. A company making this decision should assess objectively its capacity and possibility to keep low price longer than its rivals. But in all cases it is better firstly to pay attention to non-price methods of fight because it is a smarter way which is able to bring considerable advantages in the long-run as it was shown in the example.

 

     Bibliography 

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