Question

(Related to Solved Problem 14.2 on page 487 ) UPS and FedEx both struggle to deliver the surge of packages they receive during the December holiday season. According to an article in the Wall Street Journal, in 2014 , both firms considered charging Amazon and other firms rates that would be 10 percent higher for packages delivered during the week before Christmas. Such higher rates would likely have increased the profits of both firms. Neither UPS nor FedEx actually raised rates during the 2014 holiday season, but both firms did raise them during the 2016 holiday season. Use game theory to explain why in 2014 neither firm raised rates during the holiday season, but two years later both firms did.

Short answer

In 2014, neither UPS nor FedEx raised their rates because each feared losing customers to the other if they unilaterally increased their fees. However, in 2016, both corporations decided to raise their rates possibly having realized they were in a prisoner's dilemma situation. They could both improve their individual profits by simultaneous rate hikes without losing customers to the other. Applying game theory principles, we understand this as a shift from a dominant strategy (not raising rates) to a cooperative one (raising rates simultaneously).

Step-by-step solution

Identify the Players and Their Strategies

The players in this scenario are UPS and FedEx. They each have two strategies- to raise the rates or to not raise them. In 2014, neither company raised rates, and in 2016, both companies did. The moves of both the companies are interdependent, which makes this a strategic decision-making problem.

Analyze the Outcomes

Given that both companies are competitors, their actions affect the success of each other's strategies. If one company raises the rates and the other doesn't, the latter will corner the market, as customers will prefer the cheaper rates. If both companies raise their rates simultaneously, there is no alternative option that is cheaper for the customers who are likely to stick with their current service provider.

Apply the Principles of Game Theory

In 2014, neither company raised rates because neither company could guarantee that the other would follow suit. If one company raised rates and the other did not, the company with the higher rates would lose customers to the other. It became a coordination problem, with both companies choosing a dominant strategy and not raising rates in order to avoid losing customers.

Understanding the Shift in Strategy

In 2016, both companies raised rates. This suggests that between 2014 and 2016, the companies may have realized that they are in a prisoner's dilemma situation. Even though they would be better off if neither raised rates (as in 2014), both companies stand to gain individually if they both raise rates. Over time, they may have realized this and coordinated to avoid losing out on potential profits.

Key concepts

Strategic Decision-Making in Economics

When we explore the concept of strategic decision-making in the context of economics, we delve into the process whereby entities or individuals make choices that will affect their interests based on the anticipated actions of others. Particularly in an environment where entities like UPS and FedEx function in a competitive market, each decision taken by one firm impacts the outcomes of the other, emphasizing that decisions are not made in a vacuum.

Strategic decision-making involves assessing potential strategies while considering the likely responses of competitors. Just like in a game of chess, the players must anticipate moves ahead of time. In 2016, both UPS and FedEx decided to raise package rates before Christmas, likely a result of strategic planning and the recognition that parallel actions could increase their profits without losing customers to the other, given the lack of cheaper alternatives. This shift indicates a move from purely reactive strategies to more coordinated, forward-thinking decisions.

Coordination Problem in Game Theory

Connections between entities often lead to coordination problems, especially when mutual benefit is achievable but the pathway is unclear or risky. This situation arises when entities must work together to achieve their goals, but their inability to communicate or commit leads to less optimal outcomes. The scenario provided, where UPS and FedEx originally did not raise rates in 2014, exemplifies this.

In a coordination problem, companies face difficulties aligning their strategies without mutual assurances. The fear here was that unilateral rate increases would lead to a loss of market share if the competitor didn't follow suit. However, both companies found themselves struggling with the surge of packages and incurring the same high costs. Thus, in 2014, preserving the status quo was the safe bet to avoid potential losses. Over time, it seems both UPS and FedEx identified a solution to their coordination problem, aligning their strategies in 2016 to simultaneously raise rates.

Prisoner's Dilemma and Its Impact on Corporate Strategy

The prisoner's dilemma is a standard example of a game analyzed in game theory that demonstrates why two rational individuals may not cooperate, even if it appears that it is in their best interest to do so. In our UPS and FedEx case, if we view the decision to raise rates as akin to 'confessing', the ideal outcome would have been for neither to raise rates (both 'remain silent'), thereby retaining lower prices and avoiding a potential loss of customers to other competitors.

However, the fear of one firm unilaterally raising rates and gaining increased profits while the other suffers ('one prisoner confesses while the other remains silent') leads to the strategic move where both eventually raise rates to ensure they don’t find themselves at a competitive loss. By 2016, recognizing the possibility of repeatedly facing this situation every holiday season, UPS and FedEx seem to have implicitly reached the conclusion that cooperation—or in this case, simultaneous rate raising—would yield a better mutual outcome than the risk of unilateral action.