We’re excited that our article on “Applied game theory reveals competitor reactions to pricing optimization” was featured in the Pricing Advisor August 2017.
In this article, we present a case study that analyzes the importance of considering competitors’ reactions when a price-leader is planning to optimize its portfolio pricing.
Back in 2015, we conducted a study of two CPG brands in the packaged food category, one a price leader, the other a price follower. We will refer to them by the names Leader and Follower.
Applied game theory reveals competitor reactions to pricing optimization
“Existing literature and game theory (the science of logical decision making) identify two types of market players: price leaders and price followers. When a price leader optimizes its strategy, it must consider and anticipate a follower reaction based on prior evidence.
If, when you increase your price, a competitor always responds with a price increase one month later, congratulations, you are the price leader. Your competitor is following your pricing strategy.
However, if your competitor decreases their price, this aggressive reaction indicates they are not following your pricing strategy. By analyzing past competitor reactions, one can make more effective pricing decisions – and win the game.
In this study case, we applied three different Follower reactions to Leader’s price changes:
- Full: When Follower fully follows Leader
- Partial: When Follower partially follows Leader
- Aggressive: Followers reacts in opposite direction of Leader
For each different reaction, we estimated thousands of potential scenarios with price variations between sub-brands based on current scenarios (prices can shift from -10% to +15%), to find the optimal pricing strategy that Leader could adopt depending on Follower’s reaction. They came up with three findings:
- The expected revenue of optimal scenarios can change dramatically when taking into account a competitor´s reaction.
- What seems to be a good pricing strategy for the short term (the period of time before a competitor´s reaction) might backfire in the long term.
- A price leader might find it profitable to increase a brand’s price and sacrifice market share to induce a large competitor brand to follow in order to attract consumers to the leader’s other sub-brands.”