Question

Why do Coca-Cola and PepsiCo spend huge amounts on advertising? Do they benefit? Does the consumer benefit? Explain your answer by constructing a game to illustrate the choices Coca-Cola and PepsiCo make.

Short answer

Coca-Cola and PepsiCo advertise heavily to compete and maximize profits. Game theory shows they benefit, and consumers get more product information but might face higher prices.

Step-by-step solution

Understand the Question

Identify the reasons behind Coca-Cola and PepsiCo’s substantial expenditure on advertising. Think about potential benefits for both companies and consumers. Split the question into three parts: the reason for high advertising spending, the benefits to the companies, and the benefits to consumers.

Concept of a Game

Introduce the concept of a game in game theory. A 'game' in this context involves strategic interactions where the outcome for each participant (Coca-Cola and PepsiCo) depends on the actions of the others.

Set Up the Payoff Matrix

Create a payoff matrix that shows the potential outcomes depending on whether each company chooses to advertise or not. Define payoffs in terms of profit.

Analyse the Payoff Matrix

Explain the payoff matrix. Each combination of choices (advertise or not) results in different payoffs. Discuss dominant strategies if they exist and how Nash equilibrium applies here, indicating whether there is an optimal choice for both companies.

Determine if Companies Benefit

Using the payoff matrix, evaluate how each company's profit is affected by their advertising choice when considering the options available to the competitor. Conclude if Coca-Cola and PepsiCo benefit from advertising.

Determine if Consumers Benefit

Discuss how consumers are affected by the high advertising budgets. Consider factors like brand awareness, product information, and potential price effects.

Provide Conclusion

Summarize whether Coca-Cola and PepsiCo benefit from advertising and whether consumers benefit. Use the game theory analysis to support the conclusion.

Key concepts

Game Theory in Economics

Game theory is a crucial part of economics used to understand strategic interactions between different players. Players could be individuals, businesses, or even countries. The goal is to make the best decision by predicting the actions of others. It's like a chess game where each move affects the outcome. For Coca-Cola and PepsiCo, advertising is a strategic decision. Each company has to think about whether the other will also advertise. This context transforms their business decisions into a game-theory problem.

Payoff Matrix

A payoff matrix helps visualize the possible outcomes of a game. It's a table where each cell shows the resulting profits (or losses) for different strategies. For Coca-Cola and Pepsi, the strategies could be either to advertise or not advertise. Imagine a simple payoff matrix:

- If both advertise, they both earn significant but similar profits.
- If only one advertises, the advertiser gains more market share, leading to higher profits. The non-advertiser loses out.
- If neither advertises, both save on advertising costs but may lose potential customers.

This matrix helps both companies evaluate the best strategy by comparing potential outcomes.

Nash Equilibrium

Nash Equilibrium is a concept where no player can benefit by changing their strategy while the other players keep theirs unchanged. For Coca-Cola and Pepsi, if both find themselves in a situation where changing their advertising strategy won't result in better profits, they are in Nash Equilibrium.

In our example, let's say both companies choose to advertise. Neither Coca-Cola nor PepsiCo will earn more by stopping their ads if the other continues. This is a stable state where both have optimized their decisions, considering what the other does. Therefore, both advertising can theoretically be a Nash Equilibrium.

Dominant Strategies

A dominant strategy is the best action a player can take, regardless of what the others do. Let's apply this to Coca-Cola and PepsiCo:

- If advertising always yields higher profits no matter the competitor's choice, then advertising is a dominant strategy.
- Both might find that the safest bet is to advertise. This is because if one advertises and the other does not, the advertiser gains more.

In practice, this means large companies often end up with high advertising budgets because it's consistently seen as the highest payoff strategy. Even if skipping ads saves money, the risk of losing market share makes choosing to advertise the safer, dominant strategy.