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Chapter 15: Problem 14

Why do Coca-Cola and PepsiCo spend huge amounts on advertising? Do they benefit? Does the consumer benefit? Explain your answer by constructing a game to illustrate the choices Coca-Cola and PepsiCo make.

Short Answer

Expert verified
Coca-Cola and PepsiCo advertise heavily to compete and maximize profits. Game theory shows they benefit, and consumers get more product information but might face higher prices.

Step by step solution

01

Understand the Question

Identify the reasons behind Coca-Cola and PepsiCo’s substantial expenditure on advertising. Think about potential benefits for both companies and consumers. Split the question into three parts: the reason for high advertising spending, the benefits to the companies, and the benefits to consumers.
02

Concept of a Game

Introduce the concept of a game in game theory. A 'game' in this context involves strategic interactions where the outcome for each participant (Coca-Cola and PepsiCo) depends on the actions of the others.
03

Set Up the Payoff Matrix

Create a payoff matrix that shows the potential outcomes depending on whether each company chooses to advertise or not. Define payoffs in terms of profit.
04

Analyse the Payoff Matrix

Explain the payoff matrix. Each combination of choices (advertise or not) results in different payoffs. Discuss dominant strategies if they exist and how Nash equilibrium applies here, indicating whether there is an optimal choice for both companies.
05

Determine if Companies Benefit

Using the payoff matrix, evaluate how each company's profit is affected by their advertising choice when considering the options available to the competitor. Conclude if Coca-Cola and PepsiCo benefit from advertising.
06

Determine if Consumers Benefit

Discuss how consumers are affected by the high advertising budgets. Consider factors like brand awareness, product information, and potential price effects.
07

Provide Conclusion

Summarize whether Coca-Cola and PepsiCo benefit from advertising and whether consumers benefit. Use the game theory analysis to support the conclusion.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Game Theory in Economics
Game theory is a crucial part of economics used to understand strategic interactions between different players. Players could be individuals, businesses, or even countries. The goal is to make the best decision by predicting the actions of others. It's like a chess game where each move affects the outcome. For Coca-Cola and PepsiCo, advertising is a strategic decision. Each company has to think about whether the other will also advertise. This context transforms their business decisions into a game-theory problem.
Payoff Matrix
A payoff matrix helps visualize the possible outcomes of a game. It's a table where each cell shows the resulting profits (or losses) for different strategies. For Coca-Cola and Pepsi, the strategies could be either to advertise or not advertise. Imagine a simple payoff matrix:

- If both advertise, they both earn significant but similar profits.
- If only one advertises, the advertiser gains more market share, leading to higher profits. The non-advertiser loses out.
- If neither advertises, both save on advertising costs but may lose potential customers.

This matrix helps both companies evaluate the best strategy by comparing potential outcomes.
Nash Equilibrium
Nash Equilibrium is a concept where no player can benefit by changing their strategy while the other players keep theirs unchanged. For Coca-Cola and Pepsi, if both find themselves in a situation where changing their advertising strategy won't result in better profits, they are in Nash Equilibrium.

In our example, let's say both companies choose to advertise. Neither Coca-Cola nor PepsiCo will earn more by stopping their ads if the other continues. This is a stable state where both have optimized their decisions, considering what the other does. Therefore, both advertising can theoretically be a Nash Equilibrium.
Dominant Strategies
A dominant strategy is the best action a player can take, regardless of what the others do. Let's apply this to Coca-Cola and PepsiCo:

- If advertising always yields higher profits no matter the competitor's choice, then advertising is a dominant strategy.
- Both might find that the safest bet is to advertise. This is because if one advertises and the other does not, the advertiser gains more.

In practice, this means large companies often end up with high advertising budgets because it's consistently seen as the highest payoff strategy. Even if skipping ads saves money, the risk of losing market share makes choosing to advertise the safer, dominant strategy.

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Most popular questions from this chapter

Use the following news clip to work. Bud and Wise are the only two producers of aniseed beer, a New Age product designed to displace root beer. Bud and Wise are trying to figure out how much of this new beer to produce. They know (i) If they both produce 10,000 gallons a day, they will make the maximum attainable joint economic profit of \(\$ 200,000\) a day, or \(\$ 100,000\) a day each. (ii) If either firm produces 20,000 gallons a day while the other produces 10,000 gallons a day, the one that produces 20,000 gallons will make an economic profit of \(\$ 150,000\) and the other will incur an economic loss of \(\$ 50,000\). (iii) If both produce 20,000 gallons a day, each firm will make zero economic profit. Find the Nash equilibrium of the game that Bud and Wise play.

New Entrants Pose a Challenge to Boeing's Share of the Global Commercial Airplane Market Competition is going to get tougher for Boeing. Currently, the global commercial airplane market for airplanes with a seating capacity of over 100 passengers is lead by Boeing and Airbus. Last year, Boeing with 648 commercial airplane deliveries occupied 43 percent of this market. Airbus with 626 commercial airplane deliveries stood second. Source: Forbes, March 06,2014 a. According to Reuters, the market share of Boeing in the large commercial aircraft segment was above 75 percent before 1990 Describe how the structure of the airplane market has changed over the past few decades. b. If Boeing and Airbus formed a cartel, how would the price charged for airplanes and the profits made change?

Gadgets for Sale \(\ldots\) or Not How come the prices of some gadgets, like the iPod, are the same no matter where you shop? No, the answer isn't that Apple illegally manages prices. In reality, Apple uses an accepted retail strategy called minimum advertised price to discourage resellers from discounting. The minimum advertised price \((\mathrm{MAP})\) is the absolute lowest price of a product that resellers can advertise. Marketing subsidies offered by a manufacturer to its resellers usually keep the price at or above the MAP. Stable prices are important to the company that is both a manufacturer and a retailer. If Apple resellers advertised the iPod below cost. they could squeeze the Apple Stores out of their own markets. The downside to the price stability is that by limiting how low sellers can go, MAP keeps prices artificially high (or at least higher than they might otherwise be with unfettered price competition). Source: Slate, December 22, 2006 a. Describe the practice of resale price maintenance that violates the Sherman Act. b. Describe the MAP strategy used by Apple and explain how it differs from a resale price maintenance agreement that would violate the Sherman Act.

The Asian rice-exporting nations planned to discuss a proposal that they form a cartel. Ahead of the meeting, the countries said that the purpose of the rice cartel would be to contribute to ensuring food stability, not just in an individual country but also to address food shortages in the region and the world. The cartel will not hoard rice and raise prices when there are shortages. The Philippines says that it is a bad idea. It will create an oligopoly, and the cartel could price the grain out of reach for millions of people. Source: CNN, May 6,2008 a. Assuming the rice-exporting nations become a profit-maximizing colluding oligopoly, explain how they would influence the global market for rice and the world price of rice. b. Assuming the rice-exporting nations become a profit-maximizing colluding oligopoly, draw a graph to illustrate their influence on the global market for rice. c. Even in the absence of international antitrust laws, why might it be difficult for this cartel to successfully collude? Use the ideas of game theory to explain.

Use the following news clip to work. Bud and Wise are the only two producers of aniseed beer, a New Age product designed to displace root beer. Bud and Wise are trying to figure out how much of this new beer to produce. They know (i) If they both produce 10,000 gallons a day, they will make the maximum attainable joint economic profit of \(\$ 200,000\) a day, or \(\$ 100,000\) a day each. (ii) If either firm produces 20,000 gallons a day while the other produces 10,000 gallons a day, the one that produces 20,000 gallons will make an economic profit of \(\$ 150,000\) and the other will incur an economic loss of \(\$ 50,000\). (iii) If both produce 20,000 gallons a day, each firm will make zero economic profit. Construct a payoff matrix for the game that Bud and Wise must play.
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