Micro and Macro Economics

1.Suppose that your firm is considering a “negative” marketing campaign in which you compare your product to your only rival’s product.  Your rival may be considering the same strategy.  In fact the products are pretty much the same.  Explain to your boss how you and your rival may be facing a Prisoners’ Dilemma situation, assuming that your boss does not know what this is to start with.

 Answer:

I am making some assumptions for ease of explanation. Assuming that my firm is Company A and rival company is Company B.  As per given conditions Both A and B have the identical product offered at an identical price point of $10/unit. At this price point, both the companies can earn a revenue of $100/ day. Considering A and B are the only companies in the market a price drop by any firm would mean entire market being captured by that firm. Suppose that the a price drop to $9/unit means either company A or B earns $200/ day while the other earns $0. If both the firms co-operate and decide to drop the price to $9/unit, both A and B will earn $75/day in revenue. Assuming the one firm is not aware of other’s strategy we can have 4 possible cases with 4 effects

1. A drops price to $9/unit , B does not  Resulting effect- A earns revenue $200 while B makes no revenue
2. B drops price to $9/unit, A does not. Resulting effect- A makes no revenue, B makes $200
3. A and B both do not drop price i.e they continue selling product at $10/unit. Resulting effect A makes $ 100/day and B makes $ 100/day.
4.  A and B both drop price to $9/unit . A and B both make revenue of $75/unit.

Assuming that one company’s decision is constant at a time, another company can gain or lose by changing its strategy.

As per the cases, we observe that in Case1, B has the possibility to improve its situation by dropping the price to $9. In this way B will gain $75 and A will lose $125. That is effectively we see a shift to case 4. Likewise in Case 2, assuming B will charge constant price of $9, A can improve its situation by betraying B and changing price to $9. Thus we see no reason why A should not drop price to $9 and at least earn $75.

Case 3 might seem a lucrative option for both A and B as it shows a revenue of $100 for both of them. This seems to be globally optimal scenario! However, in this case we do not know company B’s strategy. B has every likelihood of dropping the price to $9 with the hope of capturing entire market. If we i.e Company A decides not to change the price, we might end up losing the market share completely to B, thus earning no revenue at all.

Now let’s look at case 4, we see that both A and B charge $9/unit. In this case if B charges $9 , and not knowing B’s price point A decides to change strategy and charge $10. A will lose all the market and B will stand to gain. The opposite case is also true i.e A will gain and B loses all the revenue if it charges anything but $9. Thus we can conclude that it is beneficial for both A and B to charge the $9 irrespective of each others strategy. This case represents the classic prisoners dilemma where it is in the best interest of the 2 suspects to co-operate to ensure pay off for both[pic 1]