MANAGERIAL ECONOMICS
Large corporations and
notes and reviewer (1st sem
midterm)
M6: Direct Price Discrimination
Price discrimination
Price discrimination is a type of
selling strategy that involves a
firm selling a good or service to
different buyers at two or more
different prices, for reasons not
necessarily associated with cost.
It is often employed in hotel
rooms, airline tickets, and
professional services offering
different prices for different
customers. For instance, when
you are paying for a seat on an
airline, the airline offers different
prices for different seats in
different locations. Because some
people are willing to pay more,
the airline taps the extra
consumer surplus by charging
those more and providing a
slightly different service.
To address the numerous
problems brought by price
discrimination, the US enacted
the Robinson-Patman Act, in full
Robinson-Patman Act of 1936,
also called Anti-Price
Discrimination Act, 1936. This
law protects small businesses
from being driven out of the
marketplace by prohibiting
discrimination in pricing,
promotional allowances, and
advertising by large franchised
companies. The Robinson-
Patman Act is also intended to
protect wholesalers from being
excluded from the purchasing
chain.
businesses receive substantial
discounts from their wholesale
suppliers. If smaller businesses
do not receive the same
discounts, they cannot offer the
same products at competitive
prices. Eventually, these small
businesses will be forced out of
the market.
As mentioned earlier, price
discrimination is the strategy of
selling the same product at
different prices to different groups
of consumers, usually based on
the maximum they are willing to
pay. The practice also surfaces in
hiding lower priced items from
customers who have a higher
willingness to pay. This is tricky
because it is socially accepted in
some cases, yet rejected in
others.
In March 2020, certain
commodities such as face masks
were sold even thirty times higher
than they are currently priced.
Towards the end of the lesson,
we shall discuss why these goods
were priced at such and look at
their demand and supply curves.
The Robinson-Patman Act, a law
that prohibits unfair trade
practices brought by price
discrimination.
Advantages of Price
Discrimination
● It helps the companies earn
higher revenue by selling the
products to a wide base of
customers with differential pricing.
● It helps create an economic
advantage to the poorer sections
of the society since they are
deprived of the goods and
services due to the high costing in
the market and due to the low
standard of living.
● It helps improve the standard of
living and the economic welfare of
the area in which the services are
provided. An example is a low-
priced telephone Service or a Wifi
network in a hilly area.
Disadvantages of Price
Discrimination
● It may impact the monopoly
power of the company since the
products are available at multiple
prices in multiple areas.
● The rich class ends up paying
more for the product thereby
indirectly paying the price for
other customers as well.
● A proper and in-depth market
study is required in order to offer
one particular product at a
different price which can be a
difficult task.
Different Types of Price
Discrimination
1. First Degree Price
Discrimination
This involves charging consumers
the maximum price that they are
willing to pay. There will be no
consumer surplus.
2. Second Degree Price
Discrimination
This involves charging different
prices depending upon the
choices of consumer e.g.,
quantity, time period, collecting
coupons
⮚ After 10 minutes phone calls
become cheaper.
⮚ Electricity is more expensive for
the first number of units. For a
higher quantity of electricity
consumed the marginal cost is
lower.
⮚ Loyalty cards reward frequent
buyers with discounts on future
products.
⮚ If you collect coupons from a
newspaper you can get a
discount.
Second degree price
discrimination is sometimes
known as indirect price
discrimination because the firm
allows consumers to choose
which price they will pay. Some
choices are offered cheaper
because they impose costs on
consumers (e.g. collecting
coupons, buying in bulk or
unsocial hours).
3. Third Degree Price
Discrimination – also known as
group price discrimination
This involves charging different
prices to different groups of
people such as:
o Student discounts,
o Senior citizen railcard
o Peak travel/ off-peak travel
o Cheaper prices by the time of
the day (e.g. happy hour’s in pubs
– usually earlier on in evening
where demand is lower.
Other Types of Price
Discrimination
● Personalized Pricing. It refers
to selling to each customer at a
different cost according to the
likes and preferences of the
customers.
● Product Versioning. It pertains
to creating a different product line
similar to a menu card in which
more options are given for the
same product with minor changes
in order to sell them at a
differential price.
● Group Pricing: It refers to
creating Sectors or markets in
which a particular price will be
charged to that market.
● Complete Discrimination: It
applies to the style of costing
where the customer’s marginal
benefits are equal to the marginal
cost of the product.
● Direct Segmentation: It
pertains to the strategy when the
seller segments the customers on
the basis of their age, sex or
preferences.
● Indirect Segmentation: It
refers to the strategy when the
seller segments the customers on
the basis of package size, the
quantity of the usage, etc.
Robinson-Patman Act
Robinson-Patman Act, in full
Robinson-Patman Act of 1936,
also called Anti-Price
Discrimination Act, U.S. law
enacted in 1936 that protects
small businesses from being
driven out of the marketplace by
prohibiting discrimination in
pricing, promotional allowances,
and advertising by large
franchised companies. The
Robinson-Patman Act is also
intended to protect wholesalers
from being excluded from the
purchasing chain.
Large corporations and
businesses receive substantial
discounts from their wholesale
suppliers. If smaller businesses
do not receive the same
discounts, they cannot offer the
same products at competitive
prices. Eventually, these small
businesses will be forced out of
the market. For instance, a giant
hardware depot locates itself in a
city that has two similar but
smaller stores. To acquire a
controlling share of the market,
the megastore continuously
undercuts its two competitors by
offering much lower prices on
popular high-volume items such
as supplies and tools. The smaller
businesses cannot match the
advertised prices of their
competitor because they cannot
sustain persistent losses in their
operating revenues.
This practice is referred to as
predatory pricing .The megastore
absorbs short-term losses as a
necessary function of driving out
its local competitors. The
outcomes are twofold. First, area
competitors are eliminated, thus
securing the megastore’s profit
margin. Second, once the
newcomer has increased its
market power, prices are set at a
higher level than before. In the
long run, revenues are restored.
A retail monopoly-by-default may
result as prices are inflated to
recoup earlier losses. For the
megastore management,
predatory pricing resembles
aggressive marketing in an
intensely competitive
environment. Price discrimination,
however, may result in small
business closures and bankruptcy
filings.
Claims of price discrimination and
predatory pricing are hard to
prove. The Robinson- Patman Act
has 10 basic requirements that
must be established for an
effective claim of discrimination.
These include, among others,
evidence of intent, interstate
commerce, goods of “like grade
and quality,” and adverse effects
on competition. As a result, the
Robinson-Patman Act is complex,
difficult to apply, and open to
multiple interpretations. Claims of
price discrimination, for example,
have been brought against
booksellers, grocery store chains,
agricultural cooperatives, and
franchised retailers.
Litigation is typically brought by
individuals and small businesses
claiming predatory pricing and
discrimination. Several
aggressive defences to the
Robinson-Patman Act exist,
however, and they include cost
justification, meeting competition,
truth in advertising, availability,
and functional discounts. The
Federal Trade Commission is
responsible for upholding
provisions of the Robinson-
Patman Act, but it is a law that is
seldom enforced by the
government.
Psychological Pricing
Psychological pricing is a set of
strategic and tactical managerial
pricing actions designed to
influence consumers’ perceptions,
decisions, and behaviors through
thinking and feeling processes. Its
goal is to deliver a high degree of
value to target consumers, while
concurrently generating healthy
revenue and profit for the
business.
Psychological pricing
strategies
1. Artificial Time Constraints
These “1-Day only” signs are
known as artificial time
constraints. Stores place these
restrictions on their sales
because they act as catalysts for
consumers to spend. If potential
customers believe that the sales
are only temporary, they’re more
likely to make their purchases
today, rather than next week.
Consumers are afraid of missing
out on such an obvious deal, so
they make the purchase in order
to avoid this potential feeling of
regret or missing out. This
strategy creates artificial demand,
urgency and fear among potential
buyers.
2. Charm Pricing
Charm pricing is the official (read
fancy) name for all those 9’s that
you see at the end of prices in
your local stores. Studies done by
researchers at MIT and the
University of Chicago have
proven that prices ending in 9
create increased customer
demand for products. This
psychological phenomena is
driven by the fact that we read
from left to right, so when we
encounter a new price at $1.99,
we see the 1 first and perceive
the price to be closer to $1.00
than it is to $2.00. In essence,
ending your price in a 9
convinces customers that the
business is offering a great deal.
The prevalence of charm pricing
has created the opposite effect as
well. While prices ending in 9
connote a “value price”, prices
ending in 0 now connote a
“prestigious price.” So, if you’re
selling a “high-class” product, like
a diamond ring, you might be
better served ending your price
with a 0 to give your customers
the impression that they’re paying
for something that is expensive
and worthwhile. For a great
example take a look at most of
the sales on Gilt Groupe’s flash
sales - all of the before prices will
end in 0s or 5s while the after
prices will end in 7s, 8s, and 9s.
3. Innumeracy
Which do you think is a better
deal? “Buy one get one free” or
“50% off a two items?” According
to a study done by researchers at
the University of Minnesota, most
people would prefer the first
option, even though the two
options are identical (buying two
items at 50% off is the same as
paying full price for one and
getting the second free).
This phenomenon is known as
innumeracy, where consumers
are unable to recognize or
understand fundamental math
principles as they apply to
everyday life.) Other ways that
innumeracy appears in pricing
include double discounting,
coupon design, and percentage
pumping.
4. Price Appearance
The design of your prices can
also have a tremendous impact
on how customers perceive the
value of your product. Longer
prices appear to be more
expensive for consumers than
shorter prices, even if they
represent the same number. This
is because subconsciously, the
longer prices take more time to
read. This effect is compounded
by the use of a “$” sign for prices.
Not only does it make the price
longer, but it also firmly relates
the number to consumers’
wallets, which exacerbates the
pain of parting with their hard
earned cash.
Similarly, prices with more
syllables appear more expensive
because consumers pronounce
prices in their heads and it takes
longer to recite extended
numbers. This is an easy tactic to
employ for your pricing as well.
Omit the “$” signs from your
pricing and if you’re pricing at a
whole number, forget the “.00” as
well. If you’re trying to combine
this tactic with charm pricing,
consider making the “.99” very
small compared to your main
price.
Demand, Supply, Panic,
Hoarding and Prices during
Pandemic
With recent updates from the
World Health Organization
warning that the virus could be
spread through respiratory
droplets produced from coughs
and sneezes, a national run on
household goods was set off in
China. At the top of the list of
items that consumers are fighting
to lay hands on are facial masks.
According to Reuters, a factory
has a demand of 200 million
masks per day compared to its
normal production rate of 400,000
a day (.concordiashanghai.org).
The primary reason for the rise in
the price of masks is due to a
shortage of masks which has
drastically risen as a result of
consumers reacting to the virus,
while the supply of masks has
remained the same. This leads to
a situation where the demand for
masks heavily outweighs the
amount of masks produced. This
shortage allows producers to
charge higher prices as people
scramble to secure masks.

The prices of face masks
eventually went down as soon as
local manufacturers started to sell
them at a much lower price.
Today, what used to be sold at
PHP1,500 per box may be
purchased at less than PHP100.
Many studies show that
customers are more likely to buy
products whose price points end
in the number nine.
M7: Making Decisions with Risk
and Uncertainty
Risk analysis and risk
management are important tools
in the management process.
Economic risk is the chance of
loss because all possible
outcomes and their probability of
happening are unknown. Actions
taken in such a decision
environment are purely
speculative, such as the buy and
sell decisions made by traders
and other speculators in
commodity, futures, and options
markets. All decision makers are
equally likely to profit as well as to
lose. Luck is the sole determinant
of success or failure.
Uncertainty exists when the
outcomes of managerial
decisions cannot be predicted
with absolute accuracy but all
possibilities and their associated
probabilities are known. Under
conditions of uncertainty,
informed managerial decisions
are possible. Experience, insight,
and prudence allow managers to
devise strategies for minimizing
the chance of failing to meet
business objectives. Although
luck still plays a role in
determining ultimate success,
managers can deal effectively
with an uncertain decision
environment by limiting the scope
of individual projects and
developing contingency plans for
dealing with failure.
Game theory, the study of
strategic decision-making,
provides the base for rational
decision making. Companies are
utilizing the science of Game
Theory to help them make high
risk or high reward strategic
decisions in highly competitive
markets and situations.
On its third year, the business
landscape will face greater
uncertainty in the post-COVID
period. Political, technological
and societal factors are believed
to be the three drivers businesses
need to watch in dealing with risk
and uncertainty.
Risk and Uncertainty
The past lesson gave us a
detailed discussion about price
discrimination and why some
sellers price discriminate
including its advantages and
disadvantages. Likewise, the
different forms of price
psychology were described and
you were tasked to give insight on
the ethical issue of the pricing
strategy. The last topic dwelt on
the Robinson-Patman Act, also
known as the Anti-Price
Discrimination Act. Today’s lesson
presents the concepts of risk and
uncertainty, and their implications
on business. The Nash
Equilibrium, Prisoner’s Dilemma,
and other game theory models.
Launching a new product, a major
change in marketing strategy or
opening your first branch could be
influenced by such factors as the
reaction of competitors, new
competitors, technological
changes, changes in customer
demand, economic shifts,
government legislation and a host
of conditions beyond your control.
These are the type of decisions
facing the senior executives of
large corporations who must
commit huge resources. The
business manager faces,
relatively, the same type of
conditions which could cause
decisions that result in a disaster
from which he or she may not be
able to recover.
Risk refers to decision-making
situations under which all
potential outcomes and their
likelihood of occurrences are
known to the decision-maker, and
uncertainty refers to situations
under which either the outcomes
and/or their probabilities of
occurrences are unknown to the
decision-maker. How decision-
makers perceive risk and
uncertainty depends on the
context of the decision and the
characteristic of the decision-
maker.
The concept ‘risk’ is a situation in
which the probability distribution
of a variable is known but its
actual value is not. Risk is an
actuarial concept. It may be
defined as an uncertainty of
financial loss on the occurrence
of an unfortunate event.
A risk is an uncertainty of loss. It
is an objectified uncertainty or a
measurable misfortune. Every
business involves some risk and
most people do not like being
involved in any risky enterprise.
The greater the risk, the higher
must be the expected gain in
order to induce them to start the
business.
Risk can be classified as
follows:
1. Pure Risk or Static Risk
Pure risk prevails where there is a
probability of loss but no chance
of gain. For example, if the firm is
gutted out by fire, the owner
sustains financial loss. If there is
no such fire accident, the owner
does not gain either. Pure risks
are insurable.
2. Speculative Risk or Dynamic
Risk
A speculative risk exists where
there is even chance for both gain
and loss. This type of risk arises
from fluctuations of prices.
Owners of shares and bonds will
gain if the price goes up and
losses it the price falls.
3. Insurable Risks
Transferable risks are also known
as insurable risks. Such risks can
be predicted, estimated and
measured in terms of money and
so are insurable.
Non-Insurable Risk
Those risks which cannot be
calculated and insured are called
non-insurable risks.
The non-insurable risks are
further classified into:
● Competitive Risk. The existing
firms may be faced with new
competitions from the newly
entered firms. The new firms can
enter into the industry any time.
As a result of this competition, the
profit of the existing firms will fall.
● Technical Risk. New
techniques of production may be
introduced. The existing firms
may not be able to follow these
new techniques. As a result, they
may incur loss.
● Risk of Government
Intervention. In the larger
interest of the country, the
government may nationalize a
number of industries. The firms in
every industry may be affected.
The government may control the
price of the products.
● Business Cycle Risk.
Depression may affect the
industry as a whole. A depression
in one industry may affect the
other industries also.
Uncertainty
Uncertainty is a situation
regarding a variable in which
neither its probability distribution
nor its mode of occurrence is
known. For instance, an
oligopolist may be uncertain with
respect to the marketing
strategies of his competitors.
Uncertainty as defined in this way
is extremely common in economic
activity.
Classification of Uncertainty
1. Demand Uncertainty
Forecasting of the demand is
essential to take decisions
regarding production, cost of
production, capital requirements
etc. Management prepares a
demand table and analyses it. All
this is done under uncertainty and
is simply a guess.
2. Production Uncertainty
In the study of production
uncertainty following points is
taken into consideration:
● What should be the quantity of
production?
● How should the Production
Schedule be plotted?
● What resources should be
employed in production process?
● How should these resources be
allocated to different production
activities?
3. Profit Uncertainty
Profit is the difference between
cost and revenue. Both cost and
revenue are uncertain. Therefore,
it is hundred percent. Uncertainty
that what will be the profit of the
firm. A man does business only in
anticipation of earnings profit but
he cannot be sure of his profit.
4. Price Uncertainty
Success of a business firm
depends to a large extent upon
determination of price for a
product—but the pricing decision
is affected by a large number of
external factors over which the
management can have no
control. Therefore, there is an
element of uncertainty in pricing
decision.
5. Cost Uncertainty
Cost of production is also an
important factor for determining
profit of the firm. Cost estimates
are based upon the historical cost
data available from the records of
a firm. It is to be noted that
different elements of cost are
always uncertain.
6. Labor Uncertainty
Labor is the force which converts
the decisions and plans of a firm
into actions. Regular supply and
efficiency of labour determines
the success of a firm. But the
supply and efficiency of labour
are always uncertain. If the
management faces a problem in
getting required labour force at
required time or if the workers do
not co-operate in the
accomplishment of organisational
objectives, the firm cannot be
successful.
7. Capital Uncertainty
There are many uncertainties in
the field of capital of a business
firm as capital market is affected
by many economic and political
factors. One cannot be sure what
and how much capital one is
going to get from the money-
market.
8. Environmental Uncertainties
Environmental factors such as
social, economic and political
circumstances in which the firm is
operating affect the process of
decision-making of a firm but it is
never certain to predict these
factors successfully.
The Game Theory
The Game theory is a theoretical
framework to conceive social
situations among competing
players and produce optimal
decision-making of independent
and competing actors in a
strategic setting. It serves as a
model of an interactive situation
among rational players. The key
to game theory is that one
player’s payoff is contingent on
the strategy implemented by the
other player. The game identifies
the players’ identities,
preferences, and available
strategies and how these
strategies affect the outcome.
Depending on the model, various
other requirements or
assumptions may be necessary.
Game theory has a wide range of
applications, including
psychology, evolutionary biology,
war, politics, economics, and
business. Despite its many
advances, game theory is still a
young and developing science.
According to game theory, the
actions and choices of all the
participants affect the outcome of
each.
Impact on Economics and
Business
Game theory brought about a
revolution in economics by
addressing crucial problems in
prior mathematical economic
models. For instance,
neoclassical economics struggled
to understand entrepreneurial
anticipation and could not handle
the imperfect competition. Game
theory turned attention away from
steady-state equilibrium toward
the market process.
In business, game theory is
beneficial for modelling
competing behaviors between
economic agents. Businesses
often have several strategic
choices that affect their ability to
realize economic gain. For
example, businesses may face
dilemmas such as whether to
retire existing products or develop
new ones, lower prices relative to
the competition, or employ new
marketing strategies. Economists
often use game theory to
understand oligopoly firm
behavior. It helps to predict likely
outcomes when firms engage in
certain behaviors, such as price-
fixing and collusion.
Although there are many types of
game theories, cooperative and
non-cooperative game theories
are the most
common. Cooperative game
theory deals with how coalitions,
or cooperative groups, interact
when only the payoffs are
known. It is a game between
coalitions of players rather than
between individuals, and it
questions how groups form and
how they allocate the payoff
among players.
Non-cooperative game theory
deals with how rational economic
agents deal with each other to
achieve their own goals. The
most common non-cooperative
game is the strategic game, in
which only the available
strategies and the outcomes that
result from a combination of
choices are listed. A simplistic
example of a real-world non-
cooperative game is Rock-Paper-
Scissors.
Game Theory Definitions
● Game. Any set of
circumstances that has a result
dependent on the actions of two
or more decision-makers
(players)
● Players. A strategic decision-
maker within the context of the
game
● Strategy. A complete plan of
action a player will take given the
set of circumstances that might
arise within the game
● Payoff. The payout a player
receives from arriving at a
particular outcome (The payout
can be in any quantifiable form,
from dollars to utility.)
● Information set. The
information available at a given
point in the game (The term
information set is most usually
applied when the game has a
sequential component.)
●Equilibrium. The point in a
game where both players have
made their decisions and an
outcome is reached
A cartel is an organization created
from a formal agreement between
a group of producers of a good or
service. An example of cartel is
the Organization of Petroleum
Exporting Countries (OPEC).
Nash Equilibrium , Prisoner’s
Dilemma, and Other Models of
the Game Theory
Nash Equilibrium is a game
theory concept that determines
the optimal solution in a non-
cooperative game in which each
player lacks any incentive to
change the initial strategy. Under
the Nash equilibrium, a player
does not gain anything from
deviating from their initially
chosen strategy, assuming the
other players also keep their
strategies unchanged. A game
may include multiple Nash
equilibria or none of them.
Nash equilibrium is one of the
fundamental concepts in game
theory. It conceptualizes the
behavior and interactions
between game participants to
determine the best outcomes. It
also allows predicting the
decisions of the players if they
are making decisions at the same
time and the decision of one
player takes into account the
decisions of other players. Nash
equilibrium was discovered by
American mathematician, John
Nash. He was awarded the Nobel
Prize in Economics in 1994 for his
contributions to the development
of game theory.
For instance, two companies are
competing: Company A and
Company B. Both companies
want to determine whether they
should launch a new advertising
campaign for their products. If
both companies start advertising,
each company will attract 100
new customers. If only one
company decides to advertise, it
will attract 200 new customers,
while the other company will not
attract any new customers. If both
companies decide not to
advertise, neither company will
engage new customers. The
payoff table is below:
Company A should advertise its
products because the strategy
provides a better payoff than the
option of not advertising. The
same situation exists for
Company B. Thus, the scenario
when both companies advertise
their products is a Nash
equilibrium.
Example of Multiple Nash
Equilibria
John and Sam are registering for
the new semester. They both have
the option to choose either a
finance course or a psychology
course. They only have 30 seconds
before the registration deadline, so
they do not have time to
communicate with each other. If
John and Sam register for the same
class, they will benefit from the
opportunity to study for the exams
together. However, if they choose
different classes, neither of them
will get any benefit.
In the example, there are multiple
Nash equilibria. If John and Sam
both register for the same course,
they will benefit from studying
together for the exams. Thus, the
outcomes finance/finance and
psychology/psychology are Nash
equilibria in this scenario.
The Prisoner’s Dilemma
The prisoner’s dilemma, one of
the most famous game theories,
was conceptualized by Merrill
Flood and Melvin Dresher at the
Rand Corporation in 1950. It was
later formalized and named by
Princeton mathematician, Albert
William Tucker. The prisoner’s
dilemma basically provides a
framework for understanding how
to strike a balance between
cooperation and competition and
is a useful tool for strategic
decision-making. As a result, it
finds application in diverse areas
ranging from business, finance,
economics, and political science
to philosophy, psychology,
biology, and sociology.
The prisoner’s dilemma scenario
works as follows: Two suspects
have been apprehended for a
crime and are now in separate
rooms in a police station, with no
means of communicating with
each other. What should the
suspects do? This is the essence
of the prisoner’s dilemma.
Evaluating Best Course of
Action
Let us begin by constructing a
payoff matrix as shown in the
table below. The “payoff” here is
shown in terms of the length of a
prison sentence (as symbolized
by the negative sign; the higher
the number the better). The terms
“cooperate” and “betray” refer to
the suspects cooperating with
each other (as for example, if
neither of them confesses) or
defecting (i.e., not cooperating
with the other player, which is the
case where one suspect
confesses, but the other does
not). The first numeral in cells (a)
through (d) shows the payoff for
Suspect A, while the second
numeral shows it for Suspect B.
The dominant strategy for a
player is one that produces the
best payoff for that player
regardless of the strategies
employed by other players. The
dominant strategy here is for
each player to defect (i.e.,
confess) since confessing would
minimize the average length of
time spent in prison. Here are the
possible outcomes:
● If A and B cooperate and stay
mum, both get one year in prison
—as shown in the cell (a).
● If A confesses but B does not, A
goes free and B gets three years
—represented in the cell (b).
● If A does not confess but B
confesses, A gets three years and
B goes free—see cell (c).
● If A and B both confess, both
get two years in prison—as the
cell (d) shows.
So if A confesses, they either go
free or get two years in prison.
But if they do not confess, they
either get one year or three years
in prison. B faces exactly the
same dilemma. Clearly, the best
strategy is to confess, regardless
of what the other suspect does.
Implications of Prisoner’s
Dilemma
The prisoner’s dilemma elegantly
shows when each individual
pursues their own self- interest,
the outcome is worse than if they
had both cooperated. In the
above example, cooperation—
wherein A and B both stay silent
and do not confess—would get
the two suspects a total prison
sentence of two years. All other
outcomes would result in a
combined sentence for the two of
either three years or four years.
In reality, a rational person who is
only interested in getting the
maximum benefit for themselves
would generally prefer to defect,
rather than cooperate. If both
choose to defect assuming the
other won’t, instead of ending up
in the cell (b) or (c) option—like
each of them hoped for—they
would end up in the cell (d)
position and each earn two years
in prison.
In the prisoner’s example,
cooperating with the other
suspect fetches an unavoidable
sentence of one year, whereas
confessing would in the best case
result in being set free, or at worst
fetch a sentence of two years.
However, not confessing carries
the risk of incurring the maximum
sentence of three years, if say A’s
confidence that B will also stay
mum proves to be misplaced and
B actually confesses (and vice
versa). This dilemma, where the
incentive to defect (not
cooperate) is so strong even
though cooperation may yield the
best results, plays out in
numerous ways in business.
Applications to Business
A classic example of the
prisoner’s dilemma in the real
world is encountered when two
competitors are battling it out in
the marketplace. Often, many
sectors of the economy have two
main rivals. In the U.S., for
example, there is a fierce rivalry
between Coca-Cola and PepsiCo
in soft drinks and Home Depot
versus Lowe’s in building
supplies. This competition has
given rise to numerous case
studies in business schools.
Other fierce rivalries include
Starbucks versus Tim Horton’s in
Canada and Apple versus
Samsung in the global mobile
phone sector. Consider the case
of Coca-Cola versus PepsiCo,
and assume the former is thinking
of cutting the price of its iconic
soda. If it does so, Pepsi may
have no choice but to follow suit
for its cola to retain its market
share. This may result in a
significant drop in profits for both
companies.
A price drop by either company
may thus be construed as
defecting since it breaks an
implicit agreement to keep prices
high and maximize profits. Thus,
if Coca-Cola drops its price but
Pepsi continues to keep prices
high, the former is defecting,
while the latter is cooperating (by
sticking to the spirit of the implicit
agreement). In this scenario,
Coca-Cola may win market share
and earn incremental profits by
selling more colas.
Payoff Matrix
Let’s assume that the incremental
profits that accrue to Coca-Cola
and Pepsi are as follows:
● If both keep prices high, profits
for each company increase by
$500 million (because of normal
growth in demand).
● If one drops prices (i.e.,
defects) but the other does not
(cooperates), profits increase by
$750 million for the former
because of greater market share
and are unchanged for the latter.
● If both companies reduce
prices, the increase in soft drink
consumption offsets the lower
price, and profits for each
company increase by $250
million.
The payoff matrix looks like this
(the numbers represent
incremental dollar profits in
hundreds of millions):
Other oft-cited prisoner’s dilemma
examples are in areas such as
new product or technology
development or advertising and
marketing expenditures by
companies.
For example, if two firms have an
implicit agreement to leave
advertising budgets unchanged in
a given year, their net income
may stay at relatively high levels.
But if one defects and raises its
advertising budget, it may earn
greater profits at the expense of
the other company, as higher
sales offset the increased
advertising expenses. However, if
both companies boost their
advertising budgets, the
increased advertising efforts may
offset each other and prove
ineffective, resulting in lower
profits—due to the higher
advertising expenses—than
would have been the case if the
ad budgets were left unchanged.
Dictator Game
This is a simple game in which
Player A must decide how to split
a cash prize with Player B, who
has no input into Player A’s
decision. While this is not a game
theory strategy per se, it does
provide some interesting insights
into people’s behavior.
Experiments reveal about 50%
keep all the money to
themselves, 5% split it
equally, and the other 45% give
the other participant a smaller
share.
The dictator game is closely
related to the ultimatum game, in
which Player A is given a set
amount of money, part of which
has to be given to Player B, who
can accept or reject the amount
given. The catch is if the second
player rejects the amount offered,
both A and B get nothing. The
dictator and ultimatum games
hold important lessons for issues
such as charitable giving
and philanthropy.
Volunteer’s Dilemma
In a volunteer’s dilemma,
someone has to undertake a
chore or job for the common
good. The worst possible
outcome is realized if nobody
volunteers. For example, consider
a company in which accounting
fraud is rampant, though top
management is unaware of it.
Some junior employees in the
accounting department are aware
of the fraud but hesitate to tell top
management because it would
result in the employees involved
in the fraud being fired and most
likely prosecuted. Being labeled
as a whistleblower may also have
some repercussions down the
line. But if nobody volunteers, the
large-scale fraud may result in the
company’s eventual bankruptcy
and the loss of everyone’s jobs.
The Centipede Game
The centipede game is an
extensive-form game in game
theory in which two players
alternately get a chance to take
the larger share of a slowly
increasing money stash. It is
arranged so that if a player
passes the stash to his opponent
who then takes the stash, the
player receives a smaller amount
than if he had taken the pot. The
centipede game concludes as
soon as a player takes the stash,
with that player getting the larger
portion and the other player
getting the smaller portion. The
game has a pre-defined total
number of rounds, which are
known to each player in advance.
Business Risks and
Uncertainty in the Post Covid-
19 Period
Over the past year, the business
landscape has become much
more precarious due to protracted
uncertainty and confusion in
pandemic response approaches,
the challenges of vaccine rollouts
and emerging virus variants - and
spillover effects into other risks.
Businesses have had to manage
dual economic and health crises,
which have driven new employee
and customer engagement
protocols, remote working on an
unprecedented scale, the re-
engineering of supply chains, and
numerous bankruptcies,
consolidations and creative
partnerships.
These developments and the
long-term risk outlook have
businesses wondering how to
prepare for what may lie ahead.
Foremost on their mind is their
survival and building resilience.
And not only in relation to
ongoing pandemic impacts and
their competitive positioning, but
also recently unleashed cyber-
attacks, catastrophic climate
events and social unrest that
demands workplace and
community change. Hence,
businesses must be ready for a
disorderly shakeout during this
volatile recovery period. And they
will need to strengthen and
constantly review their risk
mitigation strategies to improve
their resilience to future shocks.
The World Economic Forum
identified the top risks
businesses need to focus on.