TARA BEDI

Econ 292 Intermediate Microeconomic Theory Paper

December, 1998
Abstract: As a result of being caught in a prisoners dilemma, Coke and Pepsi have been involved in a price war.
Both of the companies have lowered their price to the point where the demand curve for their product intersects their
ATC (Average Total Cost) curve. This position reflects a defensive strategy, where they both minimize losses,
maximize profits and prevent the other company from increasing its market share. This has resulted in a 1.8%
decrease of soft-drink prices from last year.
A Prisoner’s Dilemma
A recent article in the Wall Street Journal cited the ongoing price war between Coca-Cola Co. and Pepsi Co. as the
causal factor in this year’s weak soft-drink prices (cite). Both Coca-Cola Co. and Pepsi Co. face a decreasing
demand curve and they therefore can influence the going market rate for soft-drinks. This year they have used this
power to undercut each other; hence soft-drink prices have decreased 1.8% from last year.
This price war is a direct result of Pepsi and Coke being caught in a prisoners dilemma, a micro-economic concept.
According to Figure 1 both companies have two pricing options. Each one can either produce Q(max.) at the point
where MR equals MC, and charge P(max.) from the corresponding point A on the demand curve. The other viable
option is for both sides to partake in a price war and either side will keep lowering their price, till they reach point B,
where the demand curve equals ATC curve. In this situation the strategic move for either company is to retain low
prices, regardless of the other side’s behavior.
Low pricing is a defensive strategy because both companies are trying to maximize profits, minimize losses, and
restrict the other company from gaining more market share. Figure 2 illustrates why this strategy allows the
companies to achieve this result. If Coca-Cola decreases its soda price, Pepsi has two pricing options. Pepsi can
maintain a high price, resulting in a profit reduction since its demand curve is elastic (though not perfectly elastic
considering its downward sloping). Pepsi’s other choice is to lower its price to Coca-Cola’s level. It would then have
a profit margin on par with Cokes (assuming that Coke’s demand curve is equally elastic as Pepsi’s).
On the other hand, if Coca-Cola decides to maintain high prices, Pepsi still has to decide between two options. Now,
Pepsi can also retain its high price, and both companies would earn profits of $1.08 billion (assuming 1.08 is 5%
higher than 1.03). Yet, there is a more beneficial option: Pepsi can cut its price, simultaneously earning profits
higher than $1.08 billion. Of course this would be at the cost of Coke’s market share. So no matter what Coke does
it is in Pepsi’s best interest to retain low prices. This is Pepsi’s dominant strategy as long as Pepsi is not forced out
of the market. Coke shares this dominant strategy, namely maintaining low soda prices. The result is a Nash
equilibrium where both players utilize the same dominant strategy in their interactions with each other. Both sides
have taken it for granted that the competitor will retain its low prices; therefore prices have not risen in the last year
and have decreased.
Due to this price war, both sides continue to price their products competitively. Yet neither side is pricing their
products at low values with the intent of being competitive. They are targeting low prices because in this situation it
is the profit maximizing point. As a result of a downward sloping demand curve, Coca-Cola Co. and Pepsi Co. have
the power to raise the selling price of soft-drinks in the market. Yet since they are caught in a prisoners dilemma,
they are forced to maintain low prices and consequently it is unlikely that cut-throat pricing in the soft-drink
industry will let up this year

The Prisoner’s Dilemma: Price War or Not*

Coca-Cola's Action

Price Maximum Price War

PepsiCo's Action $1.08 billion (P) $ .648 billion (P)

Price
Maximum
$1.08 billion (C) $1.512 billion (C)
 $1.512 billion (P) $1.03 billion (P)
Price War
$ .648 billion (C) $1.03 billion (C)

* Assume that Coca-Cola and PepsiCo obtain similar profits. We know Pepsi’s profit is $1.03 billion, 5% less than
last years. So to calculate last year’s profit: x- .05x= 1.03, so x=1.08. We take $1.08 billion to be the profit from
maximum price estimation, and $1.03 billion for the profit if both engaged in a price war. If only one company
engaged in a price war they would gain 70% of the market, and the other would only have 30% of the market.