Why Price Matching Guarantees May Not Help Consumers–The Bertrand Model
Every Tuesday is a Game Theory article at Mind Your Decisions.
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.
12 Responses to “Why Price Matching Guarantees May Not Help Consumers–The Bertrand Model”
Great read. Thanks Presh.
By Mike on Aug 28, 2007
So, there seems to be a few questions raised from your post…
What about things like branding, this is pretty big in the drug market where a generic drug *will be the exact same* thing, but much cheaper (R&D costs weren’t needed) then the first drug. However, sales data shows that brand name drugs are able to compete, not be cutting prices, but because of their name recognition.
By RohoMech on Aug 29, 2007
@Rohit: I focued on how price guarantees alone are harmful, but yes, there are other ways to price like branding. You won’t get a bidding war if consumers think products are different. There are also other ways like making bundles and keeping the price structure complicated.
By Presh on Aug 30, 2007
As a truly savvy consumer, I find price matching in general to be overrated. I have almost never used it and believe it to be more of a marketing strategy than anything.
Price differences in general are rare and more often than not inconsequential. 10% of such DIFFERENCES are even more inconsequential.
Companies in general spend huge amounts of money on marketing to set their prices exactly where they should be. For the most part, lawyers and fine print take care of discrepancies.
Proper exploitation of price matching policies requires previous knowledge of local price drops. This is actual a published issue for Circuit City, not because they lost money, but because of legal pressure from original suppliers that such information be highly controlled.
My point is that price matching is a marketing ploy and really shouldn’t be of much concern for the responsible consumer.
By Joon on Sep 6, 2007
@Joon: I agree that price matching is a marketing ploy. It’s a way a company claims to be credibly a low-price retailer. But it also eliminates the incentive to reduce prices and get customers.
I didn’t realize Circuit City had that issue; thanks for contributing that.
By Presh on Sep 6, 2007
I stumbled upon your game theory blog and it is terrific! I have a comment on your discussion of retail price matching. I thought your suggestion of retailers using the tactic to preclude a price war was fascinating. By expanding your example a bit, I have a few thoughts to build on the theory:
1) In a slightly more tedious and complex (and arguably more realistic) model, gathering information on prices would require work, one retailer would have a lower-cost business model than any other in a market, and the objective of pricing strategy would be to maximize profits (not revenue nor market share). In such an example, a price match guarantee could enable the low-cost retailer in a market to increase profits by facilitating good-old-fashioned price discrimination, in the same way that coupons and rebates do. Taking advantage of a price match requires consumers to expend effort to research and gather proof and expend effort to request the match from a store manager. If in fact a low enough percentage of consumers are willing to put forth this effort (as is true with rebates), a price match retailer could set everyday prices a little above the next-lowest-cost competitor to skim higher margins from the many consumers that will not trouble themselves to shop around. The same retailer will still earn the business of the most price-sensitive consumers, albeit at a lower margin, by offering and honoring the price match on request. Structured properly (like rebates) total profits can be increased. A price match guarantee is a sustainable strategy only for the low-cost retailer in a market, and by combining it with an everyday price slightly above the next-lowest-cost retailer, the low-cost retailer would stand to increase its profits beyond what it would make if it simply went to market as the low-cost retailer in a world where shopping around takes effort.
Could this be a possible explanation?
By Erik on Oct 18, 2007
@Erik: Wow, thanks for the very detailed comment.
You have absolutely the right idea that search costs change the dynamics. Theory suggests that if it is time-consuming to search for cheaper products, the big leaders can raise prices using price-matching policies.
As one paper states, “When search costs are high, consumers appear to accept the price-matching signal at face value and search less in the presence of a refund.”
By Presh on Oct 18, 2007
Recently Lowes (i think) has kicked off a TV marketing campaigns reinforcing this for their appliance sales. In the commercial a guy hides from the Lowes appliance salesman while gathering data via his cellphone from “spies” at the other (presumably competing) appliance stores. He finally gets all the spy information by the end of commercial and confidently purchases the appliance. On the way out of the store he tells a fellow consumer (presumably playing the same spy game) that Lowes is the “lowest price”.
The comercial is very pointed in its sales pitch, but not very convincing to me as a consumer. It rings of car saleman who say they are the lowest price in town but that they will “meet or beat any competitors price”. So to me as the consumer (when shoping common goods only on price preference) this advertising is not very convincing. I feel like the store is putting the final onus on me to price comparison (even though it seems obvious that they dont want me to price compare). Personaly I am more likely to respond to the corny Walmart commercials that their prices are “falling back”. With Walmarts advertising it seems that the store is taking the iniative to maintain low prices and that gives me greater confidence (now if i can just stomach the poor shoping conditions).
In the specific case of Lowes thier advertisment specifically of appliances may serve a primary purpose of reminding consumers that Lowes actualy has common appliances for sale and the low price guarantee may be a way of saying “dont forget to shop us”. Otherwise if everyone has my attitude toward “low price guarantee” advertising then Lowes is spending a ton of ad money on worthless advertising (and marketing people are generally bright).
By jack on Oct 22, 2007
@jack: You raise the Lowe’s commercial which is a great example. I actually think the commercial serves the same purpose as Walmart’s falling prices: it is meant to convey a signal that they are the lowest price retailer.
Though of course, we as savvy customers should not believe them.
But it might affect our psychology in any case.
Many times I know that certain places have generally low prices, so if I find some thing reasonable there, why spend the time to search?
I try to avoid that thinking since it is simply lazy–it only take a couple minutes to compare ads in advance.
By Presh on Oct 23, 2007
Great blog.
I have always been fascinated by game theory since I covered it in my economics degree over 25 years ago.
This price guarantee issue is certainly interesting and it’s something that I have blogged about recently on The Business Coaching Blog at http://businesscoaching.typepad.com/the_business_coaching_blo/2007/10/retail-price-ma.html
It’s one of the clear cases where a game theory approach can be clearly seen to apply in a way that appears to offer a great benefit and reassurance to a customer.
Of course we know the truth.
By Paul Simister, Your Profit Coach on Nov 8, 2007
@Paul Simister: I checked out your article and was surprised. I did not know that price matching guarantees are at least 82 years old. This predates the formal study of game theory that started around the 1940s. Amazing.
By Presh Talwalkar on Nov 9, 2007
Mmm interesting point.
I wonder when it really did start.
Of course before game theory became known, it may have been a genuine attempt to help the customer.
It’s only after game theory has been developed that we have come to see that it’s actually a controlling technique that takes away the pay-off for any price cutting action.
By Paul Simister, Your Profit Coach on Nov 11, 2007