Pricing Wars – Rational Explanation of an Irrational Behavior

Pricing wars are frequent in almost all industries and if you ask business directors about it, 99% of them agree that it hurts their business and they only did it because their competitor started it.

So, if Pricing Wars are a race to the bottom, why are those so frequent?

To understand that behavior in the market, the best approach is looking at “the prisoner's dilemma” from game theory that shows why two completely "rational" individuals might not cooperate, even if it appears that it is in their best interest to do so.

(This model was originally developed by Merrill Flood and Melvin Dresher in 1950)

Below you will find an example of the model adjusted to a Pricing War between two companies:

To understand this dynamic you need to keep in mind that business managers from different companies cannot speak with each other about their pricing policies (mandatory by law in many countries), therefore they are unable to meet or speak to align their pricing strategies.

This lack of communication between companies, which is imposed by most governments to promote competition, triggers a huge fear within the companies.

Business Managers feel fear? Why? 

Because, if the other company drops their prices suddenly and your company doesn´t, there is a huge risk of losing market share, therefore losing revenues to the competitor. On the other hand, your competitor feels the same fear towards your company.

So, if the companies are unable to communicate, both feel a huge risk in case the other company strikes first and that builds a great pressure on managers.

This fear automatically drives pricing aggressiveness and that pressure tends to bring prices down on both sides and by keeping almost the same market share in the end, both companies’ loose revenues after a Pricing War.

So, since both companies probably will end much worse than before, Pricing Wars are irrational, although there is a rational explanation for it.