A beautiful duopoly

How economic theory can explain the competition

between Uber and Lyft
One hundred and fifty years before John Nash received his Nobel prize, a
train left Versailles for Paris. On board were two brothers returning home
from visiting friends. Always a pleasant journey through the French
countryside, this one was, unfortunately, in peril. The train crashed and one
of the two brothers, Joseph, was severely injured with a broken bone and
other fractures. Joseph Bertrand on that day was 20 years old and was
already a professor of mathematics with a doctorate he received at the age
of 17 for a thesis in thermodynamics.

Bertrand would later develop a thesis around an economic situation in

which two companies dominate a market, formally known as the Bertrand
duopoly. He proposed that in a state of duopoly, whereby players offer a
non-differentiated product and are not in cooperation, their customers buy
from whichever one sells it for cheaper.

Bertrand’s work was one of the foundations upon which Nash would later
build. Where Bertrand defined a cutthroat competition, Nash recognized
that competitors don’t always know what the other’s cost structure is or
what they would do in response to one’s actions, therefore keep making
tactical decisions in their businesses resulting in certain payoffs. He stated
that there exists a profile of strategies such that each competitor’s strategy
is an optimal response to the other’s, there is a point of balance in which
neither competitor has anything to gain by changing strategies. That point
is called the “Nash Equilibrium.”

John Nash shared the Nobel prize in 1994 with another brilliant mind: John
Harsanyi. Harsanyi examined the uncertainty around each party’s
knowledge and understanding of the other’s decisions and how beliefs can
be embedded into a framework of game theory. These games are called
games of incomplete information. Harsanyi said that the payoff structures
are not always known and come with a certain probability distribution so
one should take probability into account when making a tactical economic
move and calculating the results.

From Bertrand to Nash to Harsanyi, many companies have struggled with

competition, conditions of duopoly, price pressures and survival. Some
survived, some did not. Others reached a profitable state of Nash
equilibrium and still exist to this day.

Fast-forward to today… here comes Uber and Lyft.

Consider a hypothetical situation where Lyft runs a promo in a specific

market. Doing so will impact Lyft’s market share, total revenue, and overall
profits. It will also impact Uber’s market share and total revenue in that
market, but not profit per ride because they have not yet responded to the
move by adjusting their price. The same situation applies to Lyft if Uber
runs a promo. They will choose to respond or not respond based on their
beliefs of the payoff they will receive. They will keep playing this game until
they conclude there’s nothing to gain by offering more promos at which
point, they will have reached Nash equilibrium.

Harsanyi’s work is quite relevant here because the two companies have a
reasonably good idea about the outcome of each action and each other’s
costs but do not precisely know what they were, and they compete with a
certain level of belief about each other’s preferences and payoffs. Based on
their beliefs, each company will have to assign a certain level of probability
to the outcomes of their actions and the responses of their competitor.

We must also note that in the very beginning, competitors know less about
each other, but the longer they play the game, the more they will learn and
make adjustments to their moves. Going public brings more transparency
about each company so with that they will learn even more. The more each
competitor will know about each other the more informed their decisions
and responses will be so the rideshare game should ultimately reach Nash
equilibrium.

So, which one will prevail? At this point, there are a number of questions
one must ask as an investor. Are Uber and Lyft in Nash equilibrium
today? If they are in Nash equilibrium, and we know that this state means
they’re losing money every day, they will ultimately deplete all reserves. If
not, what would that final state of equilibrium be? Would it be a profitable
state for these companies and their investors? In a state of Nash
equilibrium, what price would each company charge their customers in a
given market?

Secondly, do Uber and Lyft exist in a Bertrand duopoly? Their products are
identical. One driver can drive for both companies in the same car and they
often do. Bertrand would be baffled at how fierce this competition is. In his
mind, price wars would end when price equals cost leaving no profit for
either party or no economic interest to continue their businesses. In this
case, these companies convinced investors to raise massive levels of
outside capital so that they can afford to charge prices below their cost,
operating at deficits hoping they would beat the competition and at some
point, reach profitability.

There are two things companies can do to escape Bertrand duopoly: either
come up with a lower cost structure or differentiate the product. If one can
come up with a lower cost structure, such as driverless cars, and the other
does not, that one wins. If one introduces a new product, such as bikes or
scooters and breaks into a brand-new market, they escape Bertrand and
gain an edge. But as long as the companies maintain a status of non-
differentiated products, according to Bertrand, customers would go with the
cheaper of the two, prices would go lower, drivers earn less, and economic
benefits erode.
Bertrand assumed a very commoditized world and did not take into
consideration the softer elements of competition. In the absence of cost-
cutting solutions such as driverless cars, attributes such as “company
culture” come into play. If two companies charge the same price, would
consumers split 50-50 like Bertrand said, or would they pick the company
they think is “nicer?” Or, what is the premium or discount attributable to
“niceness” of companies?

In the war between Uber and Lyft, or in any other duopoly, the ability of
companies to make calculated decisions at times of competition remains a
vital piece of the puzzle. The strategy comes in two steps. First, all
decisions must be made at optimal levels reaching a state of Nash
equilibrium. At this point, there are no further decisions to make that’ll
provide an additional economic benefit to either party. Once that’s done,
then differentiation efforts begin so that the parties may escape Bertrand.
And those happen on two fronts: cost and product differentiation. It’s
certainly a complex task and both companies have smart teams in place to
make the calculations. It will be exciting to watch the battles in the years
to come.

(If you’re an investor, would it make sense to invest in both companies in a

Bertrand duopoly? Perhaps that’s like betting on both black and red in a
game of roulette. Remember, if the ball lands on zero, both bets lose!)