Why those price match guarantees may end up costing you a fortune
This week’s game theory post is motivated by a question from loyal reader JoeP about pricing strategies. If you have a question about personal finances or game theory, feel free to send me a line. Here is what JoeP wrote:
An interesting thought stuck me yesterday as I drove by the applicable billboard. Surely you’ve seen the ads by Lowe’s or Sears regarding appliances – “We’ll match our competitors’ pricing, and give you 10% of the difference”
I feel that this pricing strategy is doomed to fail. As a savvy consumer, I see that this policy will do nothing but drive me to the competitor, rather than reel me in. Think about it this way…If I’m shopping @ Sears and realize that a fridge is cheaper here than at Lowe’s, I’m just going to go to Lowe’s and get the price change and pocket the cash. The best hope for Sears and Lowe’s is to have the exact same price – and then they still lose 10%. What do you think?
JoeP raises some great points about pricing competition. I’ll first explain an economic model about pricing and then demonstrate how price matching may lead to higher prices.
Competing on Price: Monopoly versus Duopoly
Monopoly
Let’s consider a hypothetical example where Sears is a monopolist and makes refrigerators for $200. Lacking competition, Sears can raise the selling price of the refrigerator until it maximizes revenue. Let’s say this price is $300. Sears is happy, but society would be better off if the price were lower.
Duopoly
Lucky for the consumer, Lowe’s has decided to enter the market and it is able to make an identical refrigerator for the same price of $200.
What price should Lowe’s set? If it sets a price of $300, customers are indifferent between them and Sears, so Lowe’s will acquire half of the market and split the profits with Sears. But if Lowe’s sets a lower price of $299, all consumers will switch to their store. Lowe’s will effectively capture the entire market at a price just lower than the monopoly price.
But Sears will not be happy to lose all of its customers. It would respond by an even lower price of $298 so that it can recapture the market. Since the firms cannot trust each other and simply agree on a price because of anti-trust laws, they are forced to compete. Ultimately, both firms bid down the price until it drops all the way to $200.
It is a stunning economic result that a market with only two firms can achieve the lowest price of $200 because of price bidding wars.
The formal economic model of the example is called Bertrand Duopoly.
How a Price Match Guarantee makes the Model Fall Apart
Alas, the theory does not mean heavily concentrated markets are price competitive because businesses don’t play the Bertrand game. Businesses take actions to maintain profits, and one of those actions is a price match guarantee.
A price match guarantee may not help competition because of collusion and credible threats.
Collusion
Suppose Lowe’s and Sears simultaneously enter the market and want to avoid a bidding war that leaves them with no profits. They cannot legally agree to maintain high prices, so they pursue a different method. Suppose they both advertise price matching policy, and offer you 10% of the price difference. That sure seems pro-consumer, but how are the firms incentives changed?
At first, Sears and Lowe’s will both enter at a price of $300. They split the market and have healthy profits. Will a bidding war begin?
What happens if Lowe’s decides to lower its price to $299? When Lowe’s lowers its prices, customers would actually run to Sears and get a lower price via Sears’ pricing policy. In essence, Lowe’s cannot gain customers by lowering its price“”this means there is absolutely no incentive to lower prices.
The discounting policy means that the bidding war will never start! Both firms have effectively colluded to keep prices high.
Credible Threats
Why else might a store institute a price matching policy? It is a good public relations technique.
Businesses want to say “Don’t go to my competition. I have the lowest price.” But there is no reason to trust a business whose main motivation is to profit.
So a business will try to make the claim more credible even if it is not (see my earlier game theory post on how you can do this). A business may say, “I have the lowest price. I’m so sure of it, just look at my price matching policy. Heck, I’ll even give you a 10% discount.” Now that sure sounds nice.
It is so nice that other stores will try to make this claim. Suddenly, we feel like all the stores are helping us, but secretly they are keeping prices high and avoiding a bidding war.
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