Late last year, the Milwaukee Company of Friends group organized a teleconference discussion with Jim Miller, assistant professor of economics at Smith College in Northampton, Massachussetts. A dozen CoF members gathered at Manpower Inc. to explore how people can analyze and predict interactions with the author of Game Theory at Work (McGraw-Hill, 2003). Fast Company interviewed Miller about game theory, the Prisoner's Dilemma, and the danger of competing on price.
Fast Company: Why is game theory important to the business world?
Jim Miller: Game theory is important whenever people interact. Businesses use game theory when they negotiate wages, set prices, or attempt to scare competitors out of their marketplace.
FC: Why is the Prisoner's Dilemma particularly applicable to business?
Miller: The Prisoner's Dilemma shows that in certain circumstances, competition harms the competitors. Competing firms can lose profits by, for example, setting very low prices to capture market share.
Assume that two firms compete on price. They each can set either a high or low price. If they both set a high price, both firms make profits of $1,000. If they each set a low price, they each make $10. If one firm sets a high price and the other sets a low price, then the firm setting a high price has a "profit" of -$5,000 while the firm setting a low price makes $2,000.
Now assume that both firms set prices simultaneously and the game is played only once. Both firms should set a low price. If you know the other firm is going to set a low price, you are better off setting a low price and getting a profit of $10 than setting a high price and getting a profit of -$5,000. Also, if you know the other firm is going to set a high price, you are better off setting a low price and getting a profit of $2,000 than setting a high price and getting a profit of $1,000. You are better off charging a low price.
FC: In our December 2003 article on Wal-Mart, we looked at how low prices can come with a high cost. How does that relate?
Miller: I assigned that article to my Intermediate Microeconomics class at Smith last semester. Normally, economists think that market power creates inefficiencies that hurt consumers by causing them to pay prices much greater than marginal cost. That article relates to game theory by showing how Wal-Mart uses its market power to induce suppliers to give it lower prices.
FC: If competing on price is dangerous, how can companies best mitigate the risk?
Miller: Don't compete just on price. Differentiate your product from your competitors'. Give your product a different look and feel so customers won't make choices based only on price.
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