Game Theory

A framework for studying situations in which decisions are influenced by the choices of others.

Consider, for example a new company that wishes to enter a market segment against the industry leader. How should the new company set its prices? Should it go in with its original pricing scheme, or does it go in lower judging that the leader will lower prices to drive out the new entrant?

The matrix above outlines the possibilities.

Box A: If both the new company and leader adopt lower prices, they both lose (score = 0) as profits are lower all around.

Box B: If the new company goes lower price, but the leader maintains, then the new company is likely to gain market share (score = 1).

Box C: If the new company maintains its price, but the leader opts for a low price strategy then the new company is unlikely to get a foothold in the leader’s market.

Box D: If they both maintain pricing, they will both be better off as profits are maximized.

From this basic analysis the best and worst joint scenarios are clear. However, for the leader the best choice is the least worst option. Since it is already the leader if it chooses the lower price strategy, it may win (Box C) or at the worst (Box A) it will prevent the new company from gaining an advantage.