Game Theory

Why Do Supermarkets Price Match? (Game Theory)

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Why do Supermarkets Price Match?

      Do you have a price match card at your supermarket? Have you heard them offer to refund your money if you can buy it cheaper elsewhere? Why do they do it – are they being nice to their loyal customers? Actually, no. Actually, the price match promise is not even aimed at their customers, it is sending a message to their competitors. To understand why, we need to look at something that economists call ‘Game Theory’ (don’t get excited, Pictionary and Cluedo do not feature.)

     Game Theory is something that John Nash made a big contribution to (you may have heard of him – he was the person who inspired the film A Beautiful Mind. ) He showed that when individuals (you and me) or companies (Sainsbury’s) make a decision, we do not just take into account the things that will benefit us, the things that we want. We also take into account other people and competitors. Companies, when making a decision, guess what other ‘players’ in the ‘game’ might do. Supermarkets know that if they reduce their prices, the supermarket up the road will also reduce theirs. So they will both lose money. They do not want this to happen, so they make their ‘price match’ to their customers. This is sending a clear message to the other supermarkets. It says,

“If you lower your prices, we will lower ours too, so both of us will make less profit and neither will get more customers. So don’t do it.”

     Economists call this making a ‘strategic commitment’. (Economists like to make up fancy terms, it makes them feel important.) It means the shop has made itself inflexible, it has limited its own options (because when the customer tells them that baked beans cost less in Asda, they have to match that price, they can’t just say “Oh, we were only joking, sorry, you still have to pay the original price.”) They do this so their competitors will know they are serious. They are making a tough commitment (because they believe it will influence how the other shops behave and everyone will be better off. Except for the customers maybe.)

    Supermarkets have been having price wars for years. All of their actions have to be visible (no point in matching prices if your competitor doesn’t know about it) credible (their competitor has to believe that they actually will do it. If Morrisons promise a free BMW with all their loaves of bread, no one will believe that they will actually do that. Well, some people might, but not the sort of people who will be reading this) and understandable.

     But why bother with the price match thing at all? Why not just tell the other supermarkets that you will lower your price if they lower theirs, so don’t do it? Well, they are not allowed to. That would be called collusion, which is illegal. We will come to that in a little while.

     Firstly, let’s look at another company that has made a tough commitment. I like Kelloggs cornflakes, no other cornflakes are quite the same in my opinion. They are known in the cereal making world as being price leaders. They have always aggressively matched any price of any comparative cereal (not that any other cornflakes really do compare with Kelloggs.) Now, they are not allowed to tell their competitors that they will do this (it would be collusion – illegal remember.) Plus their competitors would probably just laugh and not believe them. However, they have behaved like this for about 200 years (I am guessing the time) and so all cereal manufacturers know what to expect and they behave accordingly. No one tries to out price Kelloggs, it just is not worth it, everyone loses (apart from the customers. Again.) Economists (the people who like using fancy phrases) would say the cereal companies are in ‘Nash Equilibrium’. They cannot individually change and still succeed because their competitors will step in and lower their prices too until eventually they go bust.

     There is another kind of commitment that companies make. This is called a ‘soft commitment’ and it is less aggressive, it more involves sharing the market place. So, Dominoes and Pizza Hut do not open shops in the same town. They have not agreed to do this (that would be collusion) they simply do not do it. They share the customer base rather than trying to force the other company to lower their prices.

     Another ‘soft commitment’ can be seen with Sony and Phillips. When CDs first came out in 1982, Sony produced them but Phillips (the main competitor) did not. It let Sony go first, spend lots of money on researching the new technology and then Sony flooded the market with them. It worked to both company’s advantage. Phillips had no risk, it did not invest in a new technology which might never take off, might just be a waste of money. Sony had the advantage of knowing that if it invested in new technology, it would then have an empty market place and could sell lots to recoup it’s expenditure. It suited both companies.

     Another way that companies share the market place is by aiming their products at different people. So, Illy makes expensive but delicious coffee, Nescafe makes cheaper but still drinkable coffee, Asda own brand is pretty yukky but very cheap. It is almost a class system for coffee! This is called a ‘fragmented market’. Again, the coffee producers could not agree to do this (collusion) nor was it historical (like with kelloggs) but they could see which areas their competitors were investing in (like growing only highly refined coffee beans or investing in cheap transportation in Brazil) so they could predict what everyone was doing and make their own decisions accordingly. (This got a bit messed up when the US coffee people entered the scene, but it still makes for a good example and I rather like thinking that I prefer ‘upper class coffee’!)

     Now, we have kept mentioning ‘collusion’. What is that about? Capitalism works with the belief that the market place works best if there is free competition, if everyone is trying to win the game. People believe this so strongly that they have created organisations to police this. In the UK we have the CMA (Competition Market Authority.) Other countries have different bodies, all trying to ensure a fair market place. Competition keeps the prices down and everything working efficiently.

     The exception to this, is oil. The countries that produce oil (note, countries, not companies) do collude. Which is why oil is so expensive. The actual companies don’t talk – BP cannot have a price chat (over a cup of illy coffee) with DNO – but the UK can talk to Norway. They set the price of oil (by adding tax) where they want it. They try to limit how much oil people will use.

     If we return to supermarkets, we can now see that their price match promise does not actually help us the customers very much. However, they are still trying to entice us into their shop. So, while they may not ever give away a BMW with a loaf of bread (sorry mother) they will offer us other things. We can still enjoy our free coffee and newspaper or our loyalty card or our free knife set. It all makes shopping a little less boring.

Thanks for reading.

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