While there is a degree of differentiation among general merchandise retailers l

Question

While there is a degree of differentiation among general merchandise retailers like Target and Kmart, weekly newspaper circulars announcing sales provide evidence that these firms engage in price competition. This suggests that Target and Kmart simultaneously choose to announce one of two prices for a given product: a regular price or a sale price. Suppose that when one firm announces the sale price and the other announces the regular price for a particular product, the firm announcing the sale price attracts 50 million extra customers to earn a profit of $5 billion, compared to the $3 billion earned by the firm announcing the regular price. When both firms announce the sale price, the two firms split the market equally (each getting and extra 25 million customers) to earn profits of $1 billion each. When both firms announce the regular price, each company attracts only its 50 million loyal customers and the firms each earn $3 billion in profits. If you were in charge of pricing at one of these firms, would you have a clear-cut pricing strategy? If so, explain why. If not, explain why not and propose a mechanism that might solve your dilemma (Hint: Unlike Wal-Mart, neither of these two firms guarantees “Everyday low prices.”).

Explanation / Answer

Using what game theory teaches us, we know to use the pricing strategy of maintaining the regular price. Were either company to lower their prices to the sale price, they would make higher profits for a short period of time, but after that time, the other company would react and lower their prices in order to be competitive with the first. This would lower the profits of both companies to only $1 billion, much lower than the original $3 billion they were each earning. Thus, both companies will maintain the regular price in order to maximize profit To read more about game theory and pricing strategies: http://econ.economicshelp.org/2007/05/game-theory-pricing-strategies.html http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_11/PThy_Chapter_11.html

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