Today I will look at a simplified situation where two companies are battling over a natural monopoly. Whilst they are both competing the market isn’t big enough for either of them to make a profit. Once one of them drops out then the surviving company will have a monopoly and make a profit.
If the two companies are the same then once they have started then neither will drop out even though they continue to make losses. Here’s why:
This is really a game of chicken: the best result is if one of the companies drops out at the start before they have started competing, then the other makes the maximum profit from the monopoly. The problem is that neither company wants to be the one that drops out and so they end up competing and both losing money.
Would either company drop out after they have already suffered a year of losses through competing?
If there is a chance that your opponent will drop out after a year then you never would because you are better to carry on and take the profits once he drops out. Since both companies are the same the same applies to him, he would never drop out if he thinks you might as he will miss out on the profits. This means that neither player ends up dropping out of the competition.
No-one ever drops out part way through a price war if the two companies are the same, they are playing a game of chicken and no-one wants to be the one to back down.
In reality companies are not identical so the one with some advantage (lower costs, better product, more resources) will win the price war in the end. The point of the game theory is that it shows that there is always a tendency for price wars to continue once they have started.
For those that are interested I’ll post the maths behind this on Thursday.